CONSUMER CREDIT IN THE UNITED STATES
REPORT OF
THE NATIONAL COMMISSION
ON CONSUMER FINANCE
...... .... A-
DECEMBER 1972
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NATIONAL COMMISSION ON' CONSUMER FINANCE
1016 - 16TH STREET, N.W.
WASHINGTON, D.C. 20036
December 31, 1972
To the President and Congress of the United States:
The National Commission on Consumer Finance, established by Public Law 90-321 ,
submits herewith its Report which includes the Commission’s findings and recommenda-
tions in the field of consumer credit. The Commission’s studies, enumerated in the
Report, contain the empirical data, information and analyses relied upon by the
Commission. It is our belief that such data and extensive studies, which we are making
available to the public, are as important as the Report itself. They will provide a fresh
basis for all concerned with this significant industry to consider its future in an era of
increasing public awareness.
As to the Report itself, I believe the Commission was unanimous in concluding that
a truly competitive consumer credit market, with adequate disclosure of relevant facts to
an informed consuming public, together with legislation and regulation to eliminate
excesses, will foster economic growth and serve to optimize benefits to the consumer.
As to excesses in the marketplace, our Report recommends significant additions to
the protection of consumers in the fields of creditors’ remedies and collection practices.
We have urged restrictions on remedies such as garnishment, repossession, and wage
assignment. We have recommended abolition of the holder in due course doctrine,
confessions of judgment, and harassing tactics in debt collections.
As to adequate disclosure of relevant facts, our Report urges enhanced supervision
and enforcement of the Federal Truth in Lending Act, We have also specified actions to
make the disclosure features of Truth in Lending more effective and have suggested
expanding the coverage of that Act to include disclosure of charges for credit life and
accident and health insurance as an annual percentage rate.
We also favored making federally chartered financial institutions subject to state as
well as Federal examination for compliance with state laws governing the terms and
conditions of consumer credit extensions. In addition, we recommended expanded
administrative authority over all classes of creditors.
As to our conclusion that free and fair competition is the ultimate and most
effective protector of consumers, we have recommended the elimination of restrictive
barriers to entry in consumer credit markets by permitting all creditors open access to all
areas of consumer credit. We have urged the entry of savings and loan associations and
mutual savings banks into the consumer credit market. We have recommended
prohibitions on acquisitions that would eliminate potential competition or that would
substantially increase concentration in state or local credit markets. We have also urged
that rate ceilings which constrain the development of workably competitive markets be
reviewed by those states seeking to increase credit availability at reasonable rates. Some
controversy has developed as to whether the Commission approved a specific rate
structure including 42 percent on smaller loans. The Commission has never voted for such
a rate structure and does not endorse it.
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Finally, I would note that the gathering and analyzing of original data, and
preparing the Commission’s Report have been an arduous task for which I extend special
thanks to a devoted and hard-working Commission staff under the leadership of its
Director, Robert L. Meade. Among the many experts who assisted our work, special
recognition must be given to Professor Robert P. Shay, of Columbia’s Graduate School of
Business, who contributed significantly to the design of studies. I also, of course, thank
the members of the Commission who have given their time and effort, as well as their
knowledge and expertise, to the difficult task with which the Commission was faced.
We hope that our Report and the accompanying data and studies will provide a
healthy climate for informed and intelligent discussion and continuing research in tills
vital area.
Chairman
The President
The President of the Senate
The Speaker of the House of Representatives
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MEMBERS OF THE COMMISSION
Appointed by the President
Ira M. Millstein, Chairman
Attorney
New York, New York
Ml" Pi * 13/3
TREASURY DEPARTMENT
Appointed Chairman January 20, 197)1*
to succeed Robert Braucher a
Dr. Robert W. Johnson
Professor, Purdue University
Lafayette, Indiana
Hon. Douglas M . Head
Attorney
Minneapolis, Minnesota
Appointed February 16, 1971
Appointed by the President of the Senate
Hon. John Sparkman
Senator from Alabama
Hon. William Proxmire
Senator from Wisconsin
Hon. William E. Brock
Senator from Tennessee
Appointed April 5, 1971 to succeed
Hon. John G. Tower
Senator from Texas
Appointed by the Speaker of the House of Representatives
Hon. Leonor K. Sullivan
Hon. Henry B. Gonzalez
Representative from Missouri
Representative from Texas
Appointed March 10, 1971 to succeed
Hon. Wright Patman
Representative from Texas
Hon. Lawrence G. Williams
Representative from Pennsylvania
Appointed March 10, 1971 to succeed
Hon, Seymour Halpern
Representative from New York
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STAFF OF THE COMMISSION
Robert L. Meade
Executive Director
Ruth K. Holstein
Public Information Officer
Legal
Donald B. Harper
Administrative Officer
Milton W. Schober
General Counsel
Douglas F. Greer
Consultant
Ernest A. Nagata
Harrison F. Houghton 2
William C. Paris
Doris Baenziger
Dimitrios D, Drivas
Rebecca S. Klein
Victoria A. Sackett
Wilbur H. Baldinger
Corwin D. Edwards
Stephen M. Crane 1
Economics
Research Assistant
Patricia A. Massey 3
Data Processing
Fred E. Marmarosh
Administrative and Clerical
Mildred F. Dolan
Administrative Assistant
Cheryl Bleiberg
Donald J. Hardesty
Louise R. Neely
Gwendolyn D. Smith
Other Consultants
James A. Bayton
Paul F. Smith
Alan R. Feldman
Counsel
Robert P. Shay
Consultant
Richard K. Slater
George M. Lumbard
Fern B. Horwitz
Charles A. Banister, III
Helen I. Jackson
Karen L. Ryscavage
Patricia D. Smith
John W. Boyer
William D. Warren
Part-time Student Assistants
j
John A. Bryson; Claudia C. Dawson; Beverly A. Eiserei; John C. Firman; Deborah Flint; Stephen A. Flynn; George F.
Foote; David E. Fox; Thomas L. Gough; Eftekhar Hadjimirvahabi; William M. Hannay; Larry Harbin; Jane A. Harding;
Richard D. Hardesty; Pamela R. Hevey; Cain J. Kennedy; Lowell S. Lease; Jessica A. Licker; William F. Livingston;
James F, Lonergan; Arthur M. Mason; Michael J. McEUigott; Terence P. McLarney; Mark R. Mendenhall; Michael J.
Merenda; Nonnie F. Midgette; Rosemary A. Mitchell; Michael B. Moore; Philip B. Nelson; Stephen R. Pittman; Arthur F.
Richardson; Eric D. Roiter; Marvin L. Schwartz; Terry G. Seaks; Robert A. Simpson; Patricia Spillenkothen; Penelope
Williams; and David R. Yost.
'Until February 5, 1972 ’Until September 1 !, 1971 ’Until November 3, 1971
vi
FOREWORD
The National Commission on Consumer Finance, established by Title IV of the Consumer Credit
Protection Act of 1968 (Public Law 90-321), attained its full membership on November 7, 1969 when the
President named three public members and designated one of them Chairman.
As originally constituted, Commission members included Robert Braucher, professor of law at
Harvard University, who was named Chairman; Robert W. Johnson, professor of finance at Purdue
University; and IraM. Millstein, member of the New York Bar, Presidential appointees; Senator John J.
Sparkman, Senator William Proxmire, and Senator John G. Tower, Senate appointees; and Representative
Wright Patman, Representative Leonor K. Sullivan, and Representative Seymour Halpern, House of
Representatives appointees.
When Chairman Braucher subsequently became an Associate Justice of the Supreme Judicial Court of
Massachusetts, the President designated Mr. Millstein as Commission Chairman and named Douglas M.
Head, former Attorney General for the State of Minnesota, to fill the vacancy. Later, when Senator Tower
found it necessary to resign, he was replaced by Senator William E. Brock, and when Representatives
Patman and Halpern also found it necessary to relinquish membership, they were replaced by
Representative Henry B. Gonzalez and Representative Lawrence G. Williams. Despite these membership
changes, however, a majority of the members and the Commission’s executive director, Robert L. Meade,
have served during the Commission’s entire existence. Continuity was further achieved through monthly
meetings and frequent written communications,
In a consumer message to Congress on October 30, 1969 President Nixon noted that total consumer
credit outstanding had grown during the last 25 years from $5.7 billion to $100 billion and that
Government supervision and regulation of consumer credit had become increasingly complex and difficult.
The Commission, he said, “should begin its important work immediately.”
Because of the wide area such a comprehensive subject could encompass, the Commission had to
narrow the scope of its work to fit its funding and time limitations. Even so, the Commission twice had to
ask Congress for additional time and once for additional funds. Certainly due in no small part to the
interest, understanding, and generosity of the Congress, the Commission now offers this final Report to
fulfill its Congressional mandate.
The Commission is confident that it has pioneered in collecting and presenting heretofore
unobtainable data and ground-breaking studies and analyses. In and of themselves, the collection and
dissemination of these data, the studies, and the analyses will provide a fresh and empirical basis for
legislators, the industry, and scholars to consider.
Many of the supporting studies are being published as supplements to the final report for the use of
legislators, the industry, scholars, and others interested in the basic data. Unpublished data and studies as
well as computer tapes can be read at the records center of the National Archives and Records Service,
Washington, D.C.
As to the findings, conclusions, and recommendations contained in the report, these were prepared
by the Commission staff based upon the data, studies, and analyses collected by the Commission and, more
importantly, based upon the numerous meetings of the Commission throughout its life at which all the
Commissioners had the opportunity to present their respective views as the work progressed. As in any
report of this nature, not all of the Commissioners agreed with all of the findings, conclusions, and
recommendations, as evidenced by the separate views expressed by the individual members, which separate
views follow the body of the report.
During the course of its study, the Commission held three public hearings in Washington, D.C. to
obtain facts and views from individuals, consumer organizations, industry, and Government on the subjects
of debt collection practices, responsibility for enforcement of consumer credit protection laws, and the
availability of consumer credit to women. The Commission publicly acknowledges its gratitude to witnesses
who appeared at the hearings to provide invaluable information related to ever increasing complexities in
vii
fj
the consumer credit field. The Commission also notes its gratitude to thousands of credit industry officials
who spent hours of time and effort in completing Commission questionnaires which provided priceless data.
Obviously, their assistance in providing data does not necessarily indicate their concurrence with the report
and its recommendations.
Although this report is directed to the President and to the Congress, the Commission hopes that
consumers, the consumer credit industry, state legislative bodies, and professional and academic
communities will also find that it adds substantially to their understanding of a growing industry and a
complex subject.
vm
Contents
Letter of Transmittal
Members of the Commission
Staff of the Commission
Foreword
Summary of Recommendations
Chapter 1 . An Overview of the Study and Some Conclusions
Chapter 2 . Development and Structure of Consumer Credit
Development of Consumer Credit 5
Reasons for Growth of Consumer Credit . 5
Characteristics of Consumers 5
Willingness to Incur Debt 6
Shift to Asset Ownership 6
Types of Consumer Credit 7
Statistical and Legislative Differences 7
Instalment Versus Noninstalment Credit 7
Classes of Instalment Credit 8
Classes of Noninstalment Credit 8
Holders of Consumer Credit 8
Users of Consumer Credit ]2
Is Credit Used Excessively 17
Repayments and Disposable Personal Income 17
Balance Sheet Position 18
Problems in Repaying Debt i is
Conclusion 21
Chapter 3 . Creditors’ Remedies and Contract Provisions
Introduction 23
Contract Provisions and Creditors’ Remedies 24
Contract Provisions 24
Acceleration Clauses - Default - Cure of Default 24
Attorney’s Fees 25
Confessions of Judgment - Cognovit Notes 26
Cross-Collateral 26
Household Goods 27
Security Interest - Repossession - Deficiency Judgment . . . 27
Wage Assignment 31
Creditors’ Remedies jgp. ....... . 32
Body Attachment 32
Garnishment 32
Holder in Due Course Doctrine - Waiver of Defense - Closely-Connected Loans 34
Levy on Personal Property 38
Contacting Third Parties 39
Miscellaneous Recommendations 39
Balloon Payment 39
Co-signer Agreements 39
Rebates for Prepayment 40
IX
Unfair Collection Practices
Harassment
Sewer Service
Inconvenient Venue
Debtors in Distress
Consumer Credit and Consumer Insolvency
Liability of Corporate Officers
Door-to-Door Sales
Assessment of Damages
Chapter 4. Supervisory Mechanisms
Introduction
Consumer Credit Grantors and The Enforcement Mechanism
Deposit Holding Lenders
Nondeposit Holding Lenders
Retailers and Their Assignees
Supervisory Functions of Federal and State Agencies ....
Federal Agencies
Office of the Comptroller of the Currency
Federal Reserve System
Federal Deposit Insurance Corporation
Federal Home Loan Bank Board .
National Credit Union Administration
State Agencies
Banking Departments
Nonbanking Financial Institutions
Savings and Loan Associations and Credit Unions
Mutual Savings Banks ,
Consumer Finance Companies
Other Nonbanking Financial Institutions
Offices of the Attorneys General
Adequacy of Consumer Credit Protection
Bank Supervision
Savings and Loan Association
Credit Unions
Consumer Finance Companies
Truth In Lending (TIL) .
Federal Agencies
State Agencies
The Problems in Perspective
Federal Watchdog Agency
Summary . . . 1$
Deposit Holding Institutions
Nondeposit Holding Lenders .
Retailers and Their Assignees
Better Enforcement at All Levels
Legal Services
Watchdog Agency
Exhibits . . .
41
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Chapter 5 . Credit Insurance
The Nature of Credit Insurance g 3
Group Credit Life Insurance 83
x
Group Credit Life Premiums . 84
Credit Accident and Health Insurance 84
Why Any Direct Compensation? 85
The Problems 85
Relative Benefit Position 86
The Alternative Cost Position . , . . 86
Actuarial Cost Position . 87
Chapter 6. Rate Ceilings
Historical Background 91
Ancient Times 91
Religious Prohibitions of Usury 92
Origins of Rate Ceilings in the United States 93
Current Efforts to Provide Consumer Credit at Reasonable Rates 94
United States 94
Other Countries 94
Purpose of Rate Ceilings on Consumer Credit 95
To Redress Unequal Bargaining Power 96
Do Rates Rise to Rate Ceilings? 96
Do Rates Rise for Other Reasons? 99
To Avoid Overburdening Consumers With Excessive Debts 99
What Debts are Excessive 99
Do Rate Ceilings Prevent Excessive Debt? 101
To Administer Credit Grantors as Public Utilities 102
To Assure That Consumers Pay Fair Rates for Credit 103
Cash Credit 103
Sales Credit 105
Related Issues Affecting Rates . 107
Conclusion 108
Chapter 7. Rates and Availability of Credit
Issues, Theory and Overview
Intense Competition
Imperfect Competition
Factors Determining Rates and Availability
Availability In A Competitive Market
Factors That Restrict Availability
Legal Rate Ceilings
Restrictions on Loan Size
Limitations on Creditors’ Remedies
Barriers to Entry
Market Concentration
The New Automobile Credit Market
Market Structure . .
Rates of Charge (APR’s) for New Auto Credit
Commercial Bank Direct New Auto Credit
Availability of New Auto Credit
Commercial Bank Direct Loans
Commercial Bank Indirect Financing at Auto Dealers
Finance Company Credit at Auto Dealers
Bank Concentration and Sources of Auto Financing . .
Conclusions on New Auto Credit Market
109
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xi
The Other Consumer Goods Credit Market 123
Market Structure 123
Finance Rates and Availability 124
Revolving Credit . 124
Direct Loans From Banks and Credit Unions 125
Retail-originated Closed End Instalment Credit 125
Conclusions on the Other Consumer Goods Credit Market 128
The Personal Loan Market 128
Market Structure 128
Rates of Charge and Availability 129
Finance Companies 129
Commercial Banks and Mutual Savings Banks 133
Credit Unions 133
Conclusions on the Personal Loan Market 136
Competition: Conclusions and Recommendations 136
Rate Ceiling Policy . 136
Entry Conditions 137
Mergers 138
Restructuring Concentrated Markets -. . . 138
Restrictive Arrangements 138
Cost Factors Involved in Determining Rates and Rate Ceilings 139
An Overview . 139
Operating Costs 139
Return on Invested Capital . ... . 140
Empirical Evidence of Costs of Providing Credit 141
Commercial Banks 141
Consumer Finance Companies 141
Retailers 145
Credit Unions 146
Rate Ceiling Policy Measures Recommended 147
Chapter 8. Special Problems of Availability
Discrimination 151
Definition of Discrimination 151
Sex Discrimination 152
Racial Discrimination . 153
Residential Discrimination 155
Conclusions 155
Availability of Credit to the Poor 156
Present Programs for Providing Credit to the Poor 156
Private Industry 156
Government 157
Proposed Programs 158
Dealing with Symptoms 158
Experimental Loan Program - Consumer Credit Assistance Agency 159
Treating Causes 159
Conclusions 160
Chapter 9. Federal Chartering
Precedent for Dual Chartering 161
Arguments for Federal Chartering . 162
Overcome Restrictions on Entry 162
Overcome Restrictions on Innovation 163
xii
Arguments Against Federal Chartering 164
Consumer Credit A Local Function 164
Further Segmentation of Consumer Credit Market 165
Further Fragmentation of Regulation 165
Evaluation of Federal Chartering 165
Essential Elements of Federal Chartering 166
A Supportive Posture 166
Powers of Entry and Innovation 166
Entry 166
Rates 166
Form and Terms of Consumer Credit 166
Supervision 166
Summary 167
Chapter 10. Disclosure
Background . 169
Climate for Disclosure 169
Precedent for Disclosure 170
Purpose s o f Disclosure 171
Shopping Function 171
Descriptive Function 172
Credit Versus Use of Liquid Assets . . 172
Economic Stabilization Function 174
Functions for Which Disclosure Was Not Extended 174
Evaluation of Effectiveness of Disclosure 175
Shopping Function 175
Consumers’ Awareness of APR’s 175
Institutional Knowledge As A Supplement to Disclosure 177
Inherent Limitations on Potential of Disclosure 179
Descriptive Function 182
Credit Versus Use of Liquid Assets 182
Credit Versus Delayed Consumption 182
Economic Stabilization Function ; 183
Recommendations to Increase Effectiveness of Disclosure . 1 84
Nature of Information Disclosed 184
More-Than-Four Instalment Rule 184
Real Estate Credit 185
Premiums for Credit Life and'Accident and Health Insurance 187
Agricultural Credit 187
Advertising 187
Oral Disclosures 188
Timing of Disclosure 189
Inconsistent State Requirements 189
Other Issues 189
Right of Rescission 189
Liability of Assignees 190
Tax Deductibility of Finance Charges 190
Summary 191
Chapter 1 1 . Education
Consumers’ Need to Know * 193
School Programs 194
The Curriculum 194
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Teachers and Textbooks 195
Undereducated Teachers 196
Federal and Private Aid 196
Adult Education 197
Programs Vary Widely 197
The Mass Media 198
Consumer Education in Other Countries . 198
Remedial Education 198
Nonprofit Services 199
Services for Fees 199
Roles of Bankruptcy Courts 200
Summary 200
Chapter 12. The Future of Consumer Credit
Demand-Supply Conditions in Money and Capital Markets 201
Demands for Funds 201
Supply of Funds 202
Price of Funds . 203
Growth of Revolving Credit 203
Reasons for Growth 203
The Special Role of the Multiparty Bank Credit Card 204
The Relationship of Multiparty Credit Cards to EFTS 204
Electronic Funds Transfer Systems (EFTS) 205
Obstacles to Development of Multiparty Credit Card - EFTS 205
Technical Problems 205
Opposition by Retailers 206
Opposition by Consumers 207
Legislative Obstacles 207
Risks to Consumers in Development of Multiparty Credit Card - EFTS 208
Conditions Leading to Oligopoly and Restraint of Competition 208
Possible Harmful Effects of Oligopoly Upon Consumers 209
Credit Information System 212
Future Characteristics of Credit Grantors 214
New Entrants 214
Diversification 214
Diversification to Reduce Risk 214
Diversification to Lower Costs 215
Summary 215
Separate Statements of Commission Members 217
Commission Hearings and Witnesses 265
Commission Studies 271
xiv
Footnotes
276
SUMMARY OF RECOMMENDATIONS
Contract Provisions and Creditors’ Remedies (Chapter 3)
Contract Provisions
Acceleration Clauses - Default - Cure of Default
Acceleration of the maturity of all or any part of the amount owing in a consumer
credit transaction should not be permitted unless a default as specified in the contract or
agreement has occurred.
A creditor should not be able to accelerate the maturity of a consumer credit
obligation, commence any action, or demand or take possession of any collateral, unless
the debtor is in default, and then only after he has given 14 day’s prior written notice to
the debtor of the alleged default of the amount of the delinquency (including late
charges), of any performance in addition to payment required to cure the default and of
the debtor’s right to cure the default.
Under such circumstances, for 14 days after notice has been mailed, a debtor
should have the right to cure a default arising under a consumer credit obligation by:
1. tendering the amount of all unpaid instalments due at the time of tender,
without acceleration, plus any unpaid delinquency charges; and by
2. tendering any performance necessary to cure a default other than nonpayment
of accounts due.
However, a debtor should be able to cure no more than three defaults during the
term of the contract. After curing default, the debtor should be restored to all his rights
under the consumer credit obligation as though to default had occurred.
Attorney’s Fees
Consumer credit contracts or agreements should be able to provide for payment of
reasonable attorney’s fees by the debtor in the event of default if such fees result from
referral to an attorney who is not a salaried employee of the creditor; in no event should
such fees exceed IS percent of the outstanding balance. However, thr — -cement should
further stipulate that in the event suit is initiated by the creditor and ... court finds in
favor of the consumer, the creditor should be liable for the payment of the debtor’s
attorney’s fees as determined by the court, measured by the amount of time reasonably
expended by the consumer’s attorney and not by the amount of the recovery.
Confessions of Judgment - Cognovit Notes
No consumer credit transaction contract should be permitted to contain a provision
whereby the debtor authorizes any person, by warrant of attorney or otherwise, to
confess judgment on a claim arising out of the consumer credit transaction without
adequate prior notice to the debtor and without an opportunity for the debtor to enter a
defense.
xv
Cross-Collateral
In a consumer credit sale, the creditor should not be allowed to take a security
interest in goods or property of the debtor other than the goods or property which are
the subject of the sale. In the case of “add-on” sales, where the agreement provides for
the amount financed and finance charges resulting from additional sales to be added to an
existing outstanding balance, the creditor should be able to retain his security interest in
goods previously sold to the debtor until he has received payments equal to the sales price
of the goods (including finance charges). For items purchased on different dates, the first
purchased should be deemed the first paid for; and for items purchased on the same date,
the lowest priced items should be deemed the first paid for.
Household Goods
A creditor should not be allowed to take other than a purchase money security
interest in household goods.
Security Interest - Repossession - Deficiency Judgments
A seller-creditor should have the right to repossess goods in which a security
interest exists upon default of contract obligations by the purchaser-debtor. At the time
the creditor sends notice of the cure period (14 days), and prior to actual repossession
(whether by replevin with the aid of state officers or by self-help), the creditor may
simultaneously send notice of the underlying claim against the debtor and the debtor
should be afforded an opportunity to be heard in court on the merits of such claim. The
time period for an opportunity to be heard may run concurrently with the cure period.
Where default occurs on a seemed credit sale in which the original sales price was
$1,765 or less, or on a loan in which the original amount financed was $1,765 or less and
the creditor took a security interest in goods purchased with the proceeds of such loan or
in other collateral to secure the loan, the creditor should be required to elect remedies:
either to repossess collateral in full satisfaction of the debt without the right to seek a
deficiency judgment, or to sue for a personal judgment on the obligation without
recourse to the collateral, but not both.
Wage Assignments
In consumer credit transactions involving an amount financed exceeding $300, a
creditor should not be permitted to take from the debtor any assignment, order for
payment, or deduction of any salary, wages, commissions, or other compensation for
services or any part thereof earned or to be earned. In consumer credit transactions
involving an amount financed of $300 or less, where the creditor does not take a security
interest in any property of the debtor, the creditor should be permitted to take a wage
assignment but in an amount not to exceed the lesser of 25 percent of the debtor’s
disposable earnings for any workweek or the amount by which his disposable earnings for
the workweek exceeds 40 times the Federal minimum hourly wage prescribed by section
6(a) (1) of the Fair Labor Standards Act of 1938 in effect at the time.
Creditors’ Remedies
Body Attachment
No creditor should be permitted to cause or permit a warrant to issue against the
person of the debtor with respect to a claim arising from a consumer credit transaction.
In addition, no court should be able to hold a debtor in contempt for failure to pay a
debt arising from a consumer credit transaction until the debtor has had an actual hearing
to determine his ability to pay the debt.
xvi
Garnishment
Prejudgment garnishment, even of nonresident debtors, should be abolished. After
entry of judgment against the debtor on a claim arising out of a consumer credit
transaction, the maximum disposable earnings of a debtor subject to garnishment should
not exceed the lesser of:
1 . 25 percent of his disposable earnings for the workweek, or
2. The amount by which his disposable earnings for the workweek exceeds 40
times the Federal minimum hourly wage prescribed by section 6(a) (1) of the
Fair Labor Standards Act of 1938, in effect at the time the earnings are payable.
(In the event of earnings payable for a period greater than a week, an
appropriate multiple of the Federal minimum hourly wage would be applicable,)
A debtor should be afforded an opportunity to be heard and to introduce evidence
that the amount of salary authorized to be garnished would cause undue hardship to him
and/or his family. In the event undue hardship is proved to the satisfaction of the court,
the amount of the garnishment should be reduced or the garnishment removed.
No employer should be permitted to discharge or suspend an employee solely
because of any number of garnishments or attempted garnishments by the employee’s
creditors.
Holder in Due Course Doctrine-Waiver of Defense Clauses-Connected Loans
Notes executed in connection with consumer credit transactions should not be
“negotiable instruments;” that is, any holder of such a note should be subject to all the
claims and defenses of the maker (the consumer-debtor). However, the holder’s liability
should not exceed the original amount financed. Each such note should be required to
have the legend “Consumer Note - Not Negotiable” clearly and conspicuously printed on
its face.
Holders of contracts and other evidences of debts which are executed in connection
with consumer credit transactions other than notes should similarly be subject to all
claims and defenses of the consumer-debtor arising out of the transaction, notwithstand-
ing any agreement to the contrary. However, the holder’s liability should not exceed the
original amount financed.
A creditor in a consumer loan transaction should be subject to all of the claims and
defenses of the borrower arising from the purchase of goods or services purchased with
the proceeds of the loan, if the borrower was referred or otherwise directed to the lender
by the vendor of those goods or services and the lender extended the credit pursuant to a
continuing business relationship with the vendor. In such cases, the lender’s liability
should not exceed the lesser of the amount financed or the sales price of the goods or
services purchased with the proceeds of the loan.
Levy on Personal Property
Prior to entry of judgment against a debtor arising out of a consumer credit
transaction, while a court may create a lien on the personal property of the debtor, that
lien should not operate to take or divest the debtor of possession of the property until
final judgment is entered. However, if the court should find that the creditor will
probably recover in the action, and that the debtor is acting or is about to act in a manner
which will impair the creditor’s right to satisfy the judgment out of goods upon which a
lien has been established, the court should have authority to issue an order restraining the
debtor from so acting. The following property of a consumer debtor should be exempt
from levy, execution, sale, and other similar process to satisfy judgment arising from a
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496-072 0 - 73 -2
consumer credit transaction (except to satisfy a purchase money security interest created
in connection with the acquisition of such property).
1 . A homestead to the fair market value of $5,000 including a house, mobile home,
or like dwelling, and the land it occupies if regularly occupied by the debtor and/or his
family as a dwelling place or residence and intended as such.
2. Clothing and other wearing apparel of the debtor, spouse, and dependents to the
extent of $350 each.
3. Furniture, furnishings, and fixtures ordinarily and generally used for family
purposes in the residence of the debtor to the extent of the fair market value of $2,500.
4. Books, pictures, toys for children and other such kinds of personal property to
the extent of $500.
5. All medical health equipment being used for health purposes by the debtor,
spouse, and dependents.
6. Tools of trade, including any income-producing property used in the principal
occupation of the debtor, not to exceed the fair market value of $1,000.
7. Any policy of life or endowment insurance which is payable to the spouse or
children of the insured, or to a trustee for the benefit of the spouse or children of the
insured, except the cash value or any accrued dividends thereof.
8. Burial plots belonging to the debtor and/or spouse or purchased for the benefit
of minor children to the total value of $1,000.
9. Other property which the court may deem necessary for the maintenance of a
moderate standard of living for the debtor, spouse, and dependents.
Contacting Third Parties
No creditor or agent or attorney of a creditor before judgment should be permitted
to communicate the existence of an alleged debt to a person other than the alleged
debtor, the attorney of the debtor, or the spouse of the debtor without the debtor’s
written consent.
Miscellaneous Recommendations
Balloon Payment
With respect to a consumer credit transaction, other than one primarily for an
agricultural purpose or one pursuant to open end credit, if any scheduled payment is
more than twice as large as the average of earlier scheduled payments, the consumer
should have the right to refinance the amount of that payment at the time it is due
without penalty. The terms of the refinancing should be no less favorable to the
consumer than the terms of the original transaction. These provisions do not apply to a
payment schedule which, by agreement, is adjusted to the seasonal or irregular income of
the consumer.
Cosigner Agreements
No person other than the spouse of the principal obligor on a consumer credit
obligation should be liable as surety, cosigner, comaker, endorser, guarantor, or otherwise
assume personal liability for its payment unless that person, in addition to signing the
note, contract, or other evidence of debt also signs and receives a copy of a separate
cosigner agreement which explains the obligations of a cosigner.
Rebates for Prepayment
A consumer should always be allowed to prepay in full the unpaid balance of any
consumer credit obligation at any time without penalty. In such instances, the consumer
should receive a rebate of the unearned portion of the finance charge computed in
xviii
accordance with the “balance of the digits” (otherwise known as “sum of the digits’’ or
“rule of 78’s” method) or the actuarial method. For purpose of determining the
instalment date nearest the date of prepayment, any prepayment of an obligation payable
in monthly instalments made on or before the 15th day following an instalment due date
should be deemed to have been made as of the instalment due date, and if prepayment
occurs on or after the 16th it should be deemed to have been made on the succeeding
instalment due date. If the total of all rebates due to the consumer is less than $1 no
rebate should be required.
In the event of prepayment, the creditor should not be precluded from collecting or
retaining delinquency charges on payments due prior to prepayment.
In the case of credit for defective goods, the consumer should be entitled to the
same rebate as if payment in full had been made on the date the defect was reported to
the creditor or merchant.
If the maturity of a consumer credit obligation is accelerated as a result of default,
and judgment is obtained or a sale of secured property occurs, the consumer should be
entitled to the same rebate that would have been payable if payment in full had been
made on the date judgment was entered or the sale occurred.
Upon prepayment in full of a consumer credit obligation by the proceeds of credit
insurance, the consumer or his estate should be entitled to receive the same rebate that
would have been payable if the consumer had prepaid the obligation computed as of the
date satisfactory proof of loss is furnished to the company.
Unfair Collection Practices
Harassment
No creditor, agent or attorney of the creditor, or independent collector should be
permitted to harass any person in connection with the collection or attempted collection
of any debt alleged to be owing by that person or any other person.
Sewer Service
If a debtor has not received proper notice of the claim against him and does not
appear to defend against the claim, any judgment entered shall be voided and the claim
reopened upon the debtor’s motion.
Inconvenient Venue
No creditor or holder of a consumer credit note or other evidence of debt should be
permitted to commence any legal action in a location other than (1) where the contract
or note was signed, (2) where the debtor resides at the commencement of the action,
(3) where the debtor resided at the time the note or contract was made, or (4) if there are
fixtures, where the goods are affixed to real property.
Debtors in Distress
Consumer Credit and Consumer Insolvency
Chapter XIII of the Bankruptcy Act should be expanded as endorsed by the House
of Delegates of the American Bar Association in July 1971 to permit Chapter XIII courts,
under certain circumstances, to alter or modify the rights of secured creditors when they
find that the plan adequately protects the value of the collateral of the secured creditor.
In petitions for relief in bankruptcy, the bankruptcy court should disallow claims
of creditors stemming from “unconscionable” transactions.
xix
Bankruptcy courts should provide additional staff to serve as counselors to debtors
regarding their relations with creditors, and their personal, credit, and domestic problems.
Door-to-Door Sales
In any contract for the sale of goods entered into outside the creditor’s place of
business and payable in more than four instalments, the debtor should be able to cancel
the transaction at any time prior to midnight of the third business day following the sale.
Assessment of Damages
If a creditor in a consumer credit transaction obtains a judgment by default, before
a specific sum is assessed the court should hold a hearing to establish the amount of the
debt the creditor-plaintiff is lawfully entitled to recover.
Supervisory Mechanisms (Chapter 4)
The Commission recommends that:
Legislatures and administrators in states with less than 2-1/2 man-days available per
year per small loan office reassess their staffing capabilities with the goal of improving
their ability to fulfill the examination responsibility prescribed by law.
All Federal regulatory agencies adopt and enforce uniform standards of Truth in
Lending examination.
Congress create within the proposed Consumer Protection Agency a unit to be
known as the Bureau of Consumer Credit (BCC) with full statutory authority to issue
rules and regulations and supervise all examination and enforcement functions under the
Consumer Credit Protection Act, including Truth in Lending; an independent Consumer
Credit Agency be created in the event that the proposed Consumer Protection Agency is
not established by Congress; the independent agency would have the same functions and
authorities recommended for the Bureau of Consumer Credit.
Agencies supervising federally chartered institutions undertake systematic enforce-
ment of Federal credit protection laws like Truth in Lending,
Federal law be expressly changed to authorize state officials to examine federally
chartered institutions for the limited purpose of enforcing state consumer laws, but such
authorization should in no way empower state officials to examine federally chartered
institutions for soundness, fraudulent practices, or the like; the limited state examinations
should be required by law to be performed in a manner that would not disrupt or harass
the federally chartered institutions.
State consumer credit laws be amended to bring second mortgage lenders and any
other consumer lenders under the same degree of administrative control imposed on
licensed lenders.
Congress consider whether to empower state officials to enforce Truth in Lending
and garnishment restrictions of the Consumer Credit Protection Act and any similar laws
that may be enacted.
State laws covering retailers and their assignees be amended, where necessary, to
give authority to a state administrative agency to enforce consumer credit laws against all
sellers who extend consumer credit; but administrative regulation need not and should
not entail either licensing or limitations on market access.
States which do not subject sales finance companies to enforcement of consumer
credit laws amend their laws to bring such companies under enforcement; such authority
need not and should not entail licensing or limitations on market access.
State laws be amended to give a state administrative agency authority to enforce
consumer credit laws against all credit grantors— deposit holding institutions, nondeposit
xx
holding lenders, and retailers and their assignees. This authority should include the right
to enter places of business, to examine books and records, to subpoena witnesses and
records, to issue cease and desist orders to halt violations, and to enjoin unconscionable
conduct in making or enforcing unconscionable contracts. The agency should be able to
enforce the right of consumers, as individuals or groups, to refunds or credits owing to
them under appropriate statutes.
Legal services programs- legal aid, neighborhood legal services, rural legal assistance,
public defender-continue to receive Federal, state, and local government support.
Consumer protection laws be amended, where necessary, to assure payment of legal
fees incurred by aggrieved private consumers and provide them with remedies they can
enforce against creditors who violate these laws.
The proposed BCC be authorized to establish a National Institute of Consumer
Credit to function as the BCC’s research arm.
The BCC, acting through the National Institute of Consumer Credit, be empowered
to cooperate with and offer technical assistance to states in matters relating to consumer
credit protection-examinations, enforcement, and supervision of consumer credit
protection laws.
The BCC be authorized:
(1) to require state and Federal agencies engaged in supervising institutions which
grant consumer credit to submit such written reports as the Bureau may prescribe;
— (2) to administer oaths;
(3) to subpoena the attendance and testimony of witnesses and the production of
all documentary evidence relating to the execution of its duties;
(4) to intervene in corporate mergers and acquisitions where the effect would be to
lessen competition in consumer credit markets, to include but not be limited to
applications for new charters, offices, and branches;
(5) to invoke the aid of any district court of the United States in requiring
compliance in the case of disobedience to a subpoena or order issued;
(6) to order testimony to be taken by deposition before any person designated by
the Bureau with the power to administer oaths, and in such instances to compel
testimony and the production of evidence in the same manner as authorized under
subparagraphs (3) and (5) above.
Credit Insurance (Chapter 5)
The Commission recommends that:
The finance charge earned by credit grantors should be sufficient to support the
provision of the credit service. The finance charge should not subsidize the credit
insurance service. Nor should the charge for credit insurance subsidize the credit
operation.
The proposed Bureau of Consumer Credit in the Consumer Protection Agency
make a study to determine acceptable forms of credit insurance and reasonable levels of
charge and prepare recommendations.
The states should immediately review charges for credit insurance in their
jurisdictions and lower rates where they are excessive.
Creditors offering credit life and accident and health insurance be required to
disclose the charges for the insurance both in dollars and cents and as an annual
percentage rate in the same manner as finance charges and annual percentage rates of
finance charges are required to be disclosed under the Truth in Lending Act and
regulation Z.
xxi
Rates and Availability of Credit (Chapter 7)
Although the Commission makes no generally applicable recommendation concern-
ing branch banking because conditions can vary among the states, it does recommend that
where statewide branching is allowed, specific steps be taken to assure easy new entry and
low concentration. Such steps would:
1. Give preferential treatment wherever possible to charter applications of newly
forming banks as opposed to branch applications of dominant established banks.
2. Favor branching, especially the de novo branching, whether directly or through
the holding company device when such branching promotes competition.
Banking regulators should exercise a high degree of caution in permitting
statewide branching whether directly or through the holding company device
when such branching decreases competition or increases economic concentra-
tion.
3. Encourage established banks and regulatory agencies to see that correspondent
bank services be made available (for a reasonable fee) to assist newly entering
independent banks, including the provision of loan participation agreements
when needed.
4. Disallow regional expansion by means of merger and holding company
acquisitions when such acquisitions impair competition, recognizing that
statewide measures of competition are relevant.
The Commission recommends, as did the President’s Commission on Financial
Structure and Regulation, that under prescribed conditions savings and loan associations
and mutual savings banks be allowed to make secured and unsecured consumer loans up
to amounts not to aggregate in excess of 10 percent of total assets.
The Commission recommends that the only criterion for entry (license) in the
finance company segment of the consumer credit market be good character, and that the
right to market entry not be based on any minimum capital requirements or convenience
and advantage regulations.
The Commission recommends that direct bank entry in the relatively high risk
segment of the personal loan market be made feasible by:
(1) Permitting banks to make small loans under the rate structure permitted
for finance companies;
(2) Encouraging banks to establish de novo small loan offices as subsidiary or
affiliated separate corporate entities. Regardless of corporate structure these small
loan offices, whether corporate or within other bank offices, should be subject to
the same examination and supervisory procedures that are applied to other licensed
finance companies;
(3) Exempting consumer loans from the current requirement that bank loan
production offices obtain approval for each loan from the bank's main office; and
(4) Prohibiting the acquisition of finance companies by banks when banks
are permitted to establish de novo small loan offices.
The Commission recommends that existing regulatory agencies disallow mergers or
stock acquisitions among any financial institutions whenever the result is a substantial
increase in concentration on state or local markets.
The Commission recommends that inter-institutional acquisitions be generally
discouraged even though there is no effect on intra-institutional concentration.
The Commission recommends that state regulatory agencies and legislatures review
the market organization of their respective financial industries after a 10-year trial period
of earnest implementation of the recommendations on market entry and concentration.
xxu
If, despite these procompetitive efforts, such a review discloses an inadequacy of
competition— as indicated, say, by a continuing market dominance by a few commercial
banks and finance companies or the absence of more frequent entry— then a restructuring
of the industry by dissolution and divestiture world probably be appropriate and
beneficial.
The Commission recommends that antitrust policy, both Federal and state, be alert
to restrictive arrangements in the credit industry. Any hint of agreement among lenders as
to rates, discounts, territorial allocations and the like must be vigorously pursued and
eliminated.
The Commission recommends that each state evaluate the competitiveness of its
markets before considering raising or lowering rate ceilings from present levels. Policies
designed to promote competition should be given the first priority, with adjustment of
rate ceilings used as a complement to expand the availability of credit. As the
development of workably competitive markets decreases the need for rate ceilings to
combat market power in concentrated markets, such ceilings may be raised or removed.
Discrimination (Chapter 8)
The Commission recommends that:
States undertake an immediate and thorough review of the degree to which their
laws inhibit the granting of credit to creditworthy women and amend them, where
necessary, to assure that credit is not restricted because of a person’s sex.
Congress establish a pilot consumer loan fund and an experimental loan agency to
determine whether families whose incomes are at or below the Federal Guideline for
Poverty Income Levels issued annually by OEO have the ability to repay small amounts
of money which they may need to borrow.
$1.5 million be appropriated for an experimental low income loan program to be
allocated among operating expenses, loss write-offs, and loan extensions according to
guidelines developed by an advisory committee to the Bureau of Consumer Credit.
There be continued experimentation by private industry in cooperation with
Federal, state, and local governments to provide credit to the poor.
Legislation permitting “small small” loans should be encouraged as a suitable means
of providing loans to the poor from regulated, licensed lenders.
Federal Chartering (Chapter 9)
The Commission recommends that Federal chartering of finance companies be held
in abeyance for 4 years while two complimentary courses of action are pursued:
(1) efforts should be undertaken to persuade the states to remove from existing laws and
regulations anticompetitive (and by extension, anticonsumer) restrictions on entry and
innovation and, (2) Congress should sustain the research initiated by the Commission.
If the substantive portions of the Commission’s recommendations regarding
workably competitive markets are not enacted within 4 years and states have not
eliminated barriers to entry, the Commission recommends that Congress permit Federal
chartering of finance companies with powers to supersede state laws in three basic areas
which sometimes severely limit competition in availability of credit: limitations on entry,
unrealistic rate ceilings, and restraints on amounts and forms of financial services offered
consumers.
xxiii
Disclosure (Chapter 10)
The Commission recommends that:
The Board of Governors of the Federal Reserve System regularly publish a
statistical series showing an average (and possibly a distribution) of annual percentage
rates for at least three major types of closed end consumer instalment credit: new
automobiles, mobile homes, and personal loans.
The Truth in Lending Act should be further amended to require creditors who do
not separately identify the finance charge on credit transactions involving more than four
instalments to state clearly and conspicuously in any advertisement offering credit: “THE
COST OF CREDIT IS INCLUDED IN THE PRICE QUOTED FOR THE GOODS AND
SERVICES.”
The Truth in Lending Act be amended to make clear the presumption that all
discounts or points, even when paid by the seller, are passed on to the buyer and hence
must be included in the finance charge.
Section 106(e) of the Truth in Lending Act be amended to delete as excludable
from the finance charge the following items numbered in accordance with that paragraph:
(5) Appraisal fees
(6) Credit reports
A full statement of all closing costs to be incurred be presented to a consumer prior
to his making any downpayment. In any case, a full statement of closing costs should be
provided at the time the lender offers a commitment on a consumer credit real property
transaction or not later than a reasonable time prior to final closing.
Section 104(4) of the Truth in Lending Act which exempts public utility
transactions from disclosure requirements be repealed.
Creditors be required to disclose the charge for credit insurance both in dollars and
as an annual percentage rate in the same manner as the finance charge is required to be
disclosed. Additionally, where credit insurance is advertised, that the premium be
required to be expressed as an annual percentage rate.
Exempted transactions (Section 104) of the Truth in Lending Act should include
credit transactions primarily for agricultural purposes in which the tofcd amount to be
financed exceeds $25,000, irrespective of any security interest in real property.
Creditors offering open end credit be permitted to advertise only the periodic rate
and the annual percentage rate.
Where terms other than rates are advertised, only the following terms be stated in
the advertisement:
Closed end credit
The cash price or the amount of the
loan as applicable.
The number, amount, and due dates or
period of payments scheduled to
repay the indebtedness if the credit
is extended.
The annual percentage rate, or the
dollar finance charge when the APR
is not required on small trans-
actions.
Open end credit
The minimum periodic payment re-
quired and the method of deter-
mining any larger required periodic
payment.
The method of determining the bal-
ance upon which a finance charge
may be imposed.
The periodic rate(s).
The annual percentage rate(s).
xxiv
Sections 143 and 144 of the Truth in Lending Act be amended to make clear that
there may be no expression of a rate in an advertisement of closed end credit other than
the annual percentage rate as defined in the Truth in Lending Act and regulation Z.
Legislation be adopted to permit private suits seeking injunctive relief to false or
misleading advertising.
The Truth in Lending Act be amended to provide that the Act and regulation Z
apply to oral disclosures.
State laws which are inconsistent with the Federal Truth in Lending Act or which
require disclosures which might tend to confuse the consumer or contradict, obscure, or
detract attention from the disclosures required by the Truth in Lending Act and
regulation Z be preempted by the Federal law.
The Truth in Lending Act be amended as necessary to assure that subsequent
assignees are held equally liable with the original creditor when violations of the Truth in
Lending Act are evident on the face of the agreement or disclosure statement; and that
there be equal enforcement by all appropriate agencies of this provision concerning as-
signees and all other Truth in Lending Act provisions in order to assure equal protection
to all consumers.
Both suggestions of the Board of Governors of the Federal Reserve System
pertaining to class action suits and the clarification of the definition of “transactions” be
adopted.
The Commission supports the recommendation of the Board of Governors of the
Federal Reserve System that Congress amend the Truth in Lending Act specifically to
include under Section 125 security interests that arise by operation of law.
The Commission supports the recommendation of the Board of Governors of the
Federal Reserve System that Congress amend the Truth in Lending Act to limit the time
the right of rescission may run where the creditor has failed to give proper disclosures.
Education (Chapter 11)
The Commission recommends that:
Congress support the development of improved curricula to prepare consumers for
participation in the marketplace, with adequate attention to consumer credit as one
aspect of family budgeting.
Appropriate Federal and state agencies should continue their emphasis on adult
education for low income consumers, try to reach more of them, and develop useful
programs for the elderly.
Federal resources be used to encourage expanded research and carefully monitored
pilot projects to generate and test new ideas in adult consumer education.
Business organizations support and encourage nonprofit credit counseling, provided
it is conducted for the benefit of the consumer and does not serve solely or primarily as a
collection agency.
If private debt adjusting services are allowed to continue, their activities be strictly
regulated and supervised, including their fees and advertising.
Counseling be made a mandatory requirement for obtaining a discharge in both
Chapter XIII and straight bankruptcy, unless the counselor in a particular case should
determine that counseling would be unnecessary or futile.
XXV
The Future of Consumer Credit (Chapter 12)
The Commission recommends that legislation be enacted to achieve the following
goals:
(1) Each consumer’s complaint should be promptly acknowledged by the creditor.
(2) Within a reasonable period of time a creditor should either explain to the
consumer why he believes the account was accurately shown in the billing statement or
correct the account.
(3) During the interval between acknowledgment of the complaint and action to
resolve the problem, the consumer should be free of Iiarassment to pay the disputed
amount.
(4) The penalties on creditors for failure to comply should be sufficiently severe to
prompt compliance.
The Commission recommends additional Federal and state legislation specifically
prohibiting any regulatory agencies from establishing minimum merchant discounts.
The Commission also recommends that studies be undertaken now to consider the
eventual Federal chartering and regulation of credit reporting agencies, both to assure the
accuracy and confidentiality of their credit information and to achieve open and
economical access to their data.
Chapter 1
AN OVERVIEW OF THE STUDY
AND SOME CONCLUSIONS
Congress instructed this Commission to study and
appraise the functioning and structure of the consumer
finance industry as well as consumer credit transactions
generally. More specifically, it directed the Commission
to report on the adequacy of existing arrangements to
provide consumer credit at reasonable rates, the ade-
quacy of existing supervisory and regulatory mechanisms
to protect against unfair practices and ensure the
informed use of consumer credit, and the desirability of
Federal chartering or other Federal regulatory measures.
These assignments dictated the general structure of
the Commission’s research program and set the frame-
work for its report. Not until the three areas of inquiry
had been fully explored could the Commission be in a
position to appraise the functioning and structure of the
consumer finance industry as well as consumer credit
transactions generally.
Chapter 2 traces the development of the consumer
credit industry in the United States and outlines the
structure of the market as it now exists. This chapter
points up the magnitude and importance of the
consumer credit industry both as the lubricant which
oils the wheels of our great industrial machine and as the
vehicle largely responsible for creating and maintaining
in this country the highest standard of living in the
world. It is in this context that the rest of the report is
cast-building an environment of urgency to improve the
industry which enables U.S. citizens to obtain many
necessities and enjoy life’s amenities out of current
income.
Early in the Commission’s research program it be-
came apparent that creditors’ remedies and collection
practices had a direct, personal impact on consumers and
on the price and amount of credit available. Illegal and
unconscionable collection practices are instruments of
economic and social oppression. However, a dearth of
legitimate collection tools results in higher costs, leading
to higher rates and reduced availability at the margin.
Chapter 3 discusses the Commission’s findings related to
creditors’ remedies and collection practices, assesses
their effect on the supply of credit at reasonable rates,
and contains recommendations designed to protect the
public from unfair practices.
Even the most sophisticated statutory and regulatory
schemes avail nothing if they are not adequately
enforced. Chapter 4 reviews the supervisory capabilities
of various Federal agencies with administrative authority
over grantors of consumer credit and state agencies with
similar responsibilities. Recommendations in this area
are designed not only to improve supervision and
examination functions as presently structured but also
to rearrange those functions where necessary to elimi-
nate unproductive duplication of effort and provide
more uniform and effective supervision and enforcement
of consumers’ rights under law. The chapter focuses on
improving supervisory and regulatory mechanisms to
protect the public from unfair practices.
Chapter 5 examines one component of the consumer
credit offer function found in most consumer credit
transactioris-credit life, accident, and health insurance.
Its ascendency is a relatively recent phenomenon. Such
insurance is packaged and sold with consumer credit
and, as a practical matter, . is available only from the
creditor. Is it being thrust on the unwary consumer?
Should the cost of credit insurance be made known to
the consumer in much the same way that Truth in
Lending requires the finance charge to be disclosed— as
an annual percentage rate (APR)— so that it may be
readily compared among transactions? These and other
questions come under scrutiny in Chapter 5. Recommen-
dations in this area are designed to help consumers
avoid die uninformed use of consumer credit.
In Chapter 6 the history of rate setting from ancient
times is reviewed and some major reasons advanced for
legislating maximum finance charges on consumer credit
are examined in the context of historical experience.
Chapter 6 seeks to answer the question almost as old as
mankind: do rate ceilings really protect the consumer?
Inextricably bound up widi rates is the matter of
availability, and Chapter 7 examines factors involved in
determining the price of consumer credit as well as its
availability. This chapter summarizes findings from the
1
Commission’s mid- 1971 survey of the amount and price
of consumer credit in each state and compares the
findings across states. From this empirical evidence the
Commission is able to draw conclusions about the
effects of operating costs and competition on the price
of consumer credit and the effects of rate ceilings and
competition on the availability of consumer credit.
In Chapter 8 discrimination-race, sex, economic
status-in the granting of credit is examined. Recommen-
dations here and in Chapter 6 go to the very heart of the
first specific assignment from Congress: the adequacy of
existing arrangements to provide consumer credit at
reasonable rates.
The second specific Congressional charge-to report
on the adequacy of existing legal mechanisms to insure
the .informed use of consumer credit— is the point of
departure for Chapter 10, which deals with disclosure
under the Truth in Lending Act. Here the Commission
seeks to determine whether Truth in Lending is doing its
job. Are consumers aware of APR’s and other credit
terms? Are consumers avoiding the uninformed use of
credit? Finally, Chapter 10 examines problem areas
which the Commission perceives to exist and suggests
improvements to eliminate barriers to awareness of
consumer credit terms which inhibit the informed use of
credit.
Closely allied with the subject of disclosure and the
Commission’s recommendations to make disclosure
more effective are education and information. Chapter
11 reviews existing consumer education programs and
their particular concern or lack of concern with
credit— in elementary and secondary schools, in colleges
and at the adult education level. If consumers do not
know what is required to be disclosed to them in
connection with consumer credit transactions, or what
the APR and other disclosures mean and how they may
be used, they cannot effectively shop for the best credit
“buy” or avoid the uninformed use of credit. Recom-
mendations in this chapter are an extension of those
developed in the preceding chapter.
The third specific mandate from Congress directs the
Commission to report on the desirability of Federal
chartering of consumer finance companies, and Chaptei
9 addresses itself to that task. The whole concept of
Federal chartering of nondeposit consumer finance
companies is a novel and challenging one, and this
chapter discusses its “pros” and “cons.” Rather than
recommendations, the Commission offers guidelines for
the Congress to consider in determining the proper role
of, and when to resort to, federally chartered finance
companies.
Chapter 12 takes a look into the future. This chapter
plots the likely developments in the consumer credit
industry, including an assessment of the importance of
the almost inevitable electronic funds transfer system
(EFTS) and its companion, on-line electronic credit
authorization. Recommendations focus particularly on
the operation of these systems— the concern being
twofold: (1) that both systems be open to all grantors of
consumer credit, and (2) that the systems not be
managed, manipulated, or otherwise used as instruments
for invasion of the privacy of consumers involved with
the system.
It remains then for the Commission to appraise the
functioning and structure of the consumer finance
industry, as well as consumer credit transactions gener-
ally. Naturally, this appraisal is based on studies which
the Commission conducted and commissioned, and is
covered in detail in later chapters of this report.
As Congress recognized, such an appraisal must begin
(and end) with the issue of whether the industry
provides adequate consumer credit to those who want it
at reasonable rates. Unfortunately, the Commission has
been able to devise no empirical method for determining
who should get credit, how much credit, what kind of
credit, and at what price.
It is questionable whether legislators want to begin
making the intricate social judgments involved in design-
ing laws to spell out who should get what kind of credit,
how much, and at what rate. Most legislators attempt at
all times to represent the best interests of their constitu-
ents. But their expertise is in the field of laws and
statutes, not in rulemaking and regulations required to
specify what part of a family’s income could safely be
devoted to monthly payments on credit obliga-
tions— given such variables as size of family, age of wage
earners, nature of employment, and so on. This is the
kind of activity the industry itself is constantly working
on and attempting to improve by means of its credit
scoring systems. The profit motive should be strong
enough in our economy to assure that credit grantors
will try to make as much credit available as possible at
“fair” prices and that if one creditor’s “blind spot”
keeps him from extending credit to a creditworthy
individual, another creditor will probably jump at the
chance.
This does not mean that there is no role for the
legislator in the area of consumer credit. There are
critical functions— namely: (1) to promote and assure
the maintenance of what the Commission deems to be
the key ingredient of a finance industry capable of
providing an adequate supply of credit at reasonable
rates— competition among numerous alternate sources of
credit; (2) to assure access by all to these alternate
sources of credit; and (3) to prevent excesses which the
“system” may invoke against the borrower,
To expand these functions we note: in our economy,
concededly the most successful type yet developed,
consumer credit has played a vital role. It has done so,
moreover, by growing, like Topsy, on its own. It has
2
adjusted to differing times, economic needs, consumer
goods, geographical distinctions, and so on with a minor
amount of tinkering on the part of the government.
Such tinkering as governments have engaged in has been
of a negative variety tending to restrain and restrict. But
even given government interference (not assistance), the
consumer finance industry through the play of market
forces— competition— has provided a great number of
Americans with consumer credit at rates to which they
apparently do not object, for they come back for more.
As already noted, the Commission cannot judge
whether all have obtained “all” the credit of the “type”
they wanted, that they were “entitled” to, at a “fair”
rate. Nor can it say that the price of hamburger or shoes
was “fair” at any given- time, or that more of either
might be better. In almost all instances in our economic
system, we look toward a marketplace, If sufficient
alternative sources compete for patronage, it is assumed
that the price and supply are “fair”, because they are set
by free competitive forces.
The Commission perceives no reason to assume
that-in general- competition will not have the same
result in the consumer credit area. Its principal assess-
ment of the consumer credit system is therefore that the
essentials of how much credit, to whom, and at what
price should be left to the free choice of consumers in
the marketplace— provided that that marketplace is
competitive. The primary role of legislation and regula-
tion should be to promote and assure the maintenance
of real competition in the form of numerous alternate
sources of supply of a variety of forms of consumer
credit.
As already noted, if anything, state legislation espe-
cially has tended to restrain competition and unneces-
sarily segment the consumer credit market. Succeeding
chapters in this report will demonstrate how many of
the existing laws and regulations tend to inhibit competi-
tion in the granting of credit. They consist of unrealistic
rate structures including restrictions on the size and
maturities of certain types of loans; convenience and
advantage statutes and other licensing laws which oper-
ate to restrain free access to the credit granting market;
laws which promote segmentation of the supply side of
the market such as “brick wall” and similar provisions
which limit the ability of retailers and other types of
firms from making on-premise cash loans; statutes which
prohibit savings and loan associations, mutual savings
banks, and life insurance companies from making
consumer loans; restrictions which prevent banks from
availing themselves of small loan rates; and other
limitations on inter- and intra-state branch banking.
The Commission urges, therefore, that legislators
begin to remove these impediments to competition and
this segmentation of consumer credit suppliers in order
to achieve, insofar as is consistent with other policies,
the broadest penetration by all credit grantors in all
fields of consumer credit. This will assure the consumer
access to a variety of credit sources and types of credit
and, consequently, of the benefits of a competitive
marketplace.
The Commission would further urge that antitrust
policy enforcers, both Federal and state, be particularly
alert to the dominance of consumer credit markets by a
few firms, to barriers to entry, and to restrictive
arrangements in the credit industry. Of particular con-
cern are bank holding companies’ acquisitions in related
consumer credit fields (small loan companies, for exam-
ple) which reduce the number of creditors in many
markets and eliminate competition and potential compe-
tition between the acquiring bank and small loan
companies. The Commission would opt, instead, for
providing direct bank access to the small loan market by
eliminating restrictive legislation. Perhaps in such in-
stances, toehold acquisitions might be countenanced in
separate geographical areas but this obviously will
depend on a variety of circumstances. Of course, any
hint of agreement among lenders as to rates, discounts,
territorial allocations and the like must be vigorously
pursued and eliminated. Further, such antitrust policy
should not be the exclusive province of Attorneys
General charged with enforcement but should be the
underlying principle of regulatory agencies supervising
various aspects of the consumer credit market such as
the Board of Governors of the Federal Reserve System,
the Federal Deposit Insurance Corporation, state bank-
ing agencies, and so on. The Commission recognizes that
insofar as those agencies are concerned, consumer credit
may be but one function of institutions subject to their
regulation and that their ultimate decision must be based
upon many interrelated considerations. Nonetheless, no
harm will be done to current supervisory responsibilities
if competition for consumer borrowers is adopted as a
policy guideline to be factored into ultimate judgments.
The Commission urges that adoption.
As in any other field of endeavor, the Commission
recognizes that in tills country we do not have a total
laissez-faire economy. To the degree that there is
adequate competition, the government will generally
leave that field alone, subject to important qualifica-
tions: conflict with other policy considerations; elimina-
tion, in the interests of the public, of excesses in the
marketplace; or, to put it another way, protection of the
consuming public from practices deemed unfair or
unwise. This, then, is the second area for legislative and
regulatory concern-the elimination or modification of
practices in the consumer credit field deemed unduly
harsh or otherwise inappropriate-such as certain collec-
tion practices, billing practices, and credit information
practices. However, legislators should be aware of
proposals disguised as measures to “protect” consumers,
3
such as “brick wall” provisions and licensing require-
ments, which are really intended to protect industry
from the goad of competition.
Further, to assure that competition is meaningful, the
legislator and the regulator must be vigilant in providing
the basis for the consumer’s “right to know.” While
Truth in Lending is a giant step in this direction, it
should continuously be monitored and assessed for
potential improvements.
Underlying the Commission’s belief that competition
is the best regulator of the consumer credit marketplace
is its belief that a competitive system cannot be “half
free.” If there is to be competition, then it follows that
such competition should also be the governor of rates as
well as other aspects of credit granting (amount, type,
and so forth). It would be inconsistent to turn to the
industry and attempt to regulate and eliminate practices
which affect operating costs but at the same time limit
the rate by fiat so that it cannot seek its own level. And
yet this is precisely what legislators have done. For
example, the effective elimination of some creditors’
legal collection devices increases bad debt and collection
expenses. When such elimination is not accompanied by
a rate structure which recognizes and allows for those
increased costs to be covered, less credit is available than
would be at equilibrium conditions. The Commission
recommends a consistent approach. If there is to be free
access, open competition, and elimination of harmful or
inappropriate practices, then inhibiting rate ceilings
should be reviewed and revised to allow competitive
forces to operate.
Finally, the Commission fails to see why every citizen
of the United States is not entitled to qualify for
participation in some part of the credit system herein
advocated. It can find no validity in the proposition that
when the legislature of a particular state refuses to move
away from anachronistic notions, its citizens should
suffer deprivation of credit afforded others of equal
standing. Accordingly, the Commission urges as its first
choice the adoption of state laws designed both to assure
fair treatment of all consumers and to give all credit
grantors equal opportunity to compete. Failing this, the
Commission’s second choice is to urge Federal legislation
to accomplish this goal. Enforcement, however, is too
broad to assign other than to the states, perhaps with
Federal monitoring.
In this connection the Commission notes that state as
well as Federal enforcement of laws dealing with
consumer credit has been uneven at best, and that
definite improvement is called for. Passage of laws
ultimately left in desuetude is no help to borrowers or
creditors.
The foregoing, then, constitutes the Commission’s
overall recommended legislative and regulatory ap-
proach: removal of impediments and barriers, manmade
and statemade, to the operation of competitive forces,
proposals to assist vigilant legislatures and regulators to
combat monopoly and restrictive practices, elimination
of market excesses, and continued efforts to assure that
the consumer will have full knowledge of his credit
transactions, thereby permitting rates to be set by
workable competition in the marketplace.
This goal cannot be achieved overnight, but the
Commission is persuaded that it can be achieved within a
reasonable period of time.
Chapter 2
DEVELOPMENT AND STRUCTURE OF
CONSUMER CREDIT
DEVELOPMENT OF CONSUMER CREDIT
Consumer credit is not a 20th century phenomenon
in the United States; it was an accepted fact of life in the
early Colonies. The image of the sturdy, self-reliant,
resourceful pioneer who always paid cash for his staples
and his tools may be the one imparted by some accounts
of early colonial life, but it is not entirely accurate.
Retail credit was available to farmers on a crop-to-crop
basis. When they were short on cash, they did as many
consumers do today-they traded their expectations of
future income for goods and services from local mer-
chants. Generally, merchants levied no direct finance
charge, but the cost of credit was built into the price of
the merchandise. Furniture was often sold on the
instalment plan. One writer reports that over nine-tenths
of the sales of David Evans, colonial cabinet maker, were
made on credit. 1 Pianos, books, and sewing machines
were sold on the instalment plan around the middle of
the 19th century. Although automobiles had been
produced earlier, they were not sold on the basis of
monthly payments until about 1910. 2 The rapid growth
in the credit sale of automobiles provided the basis for
both the mass market necessary to their economical
production and a remarkable increase in the volume of
consumer credit.
Because the usury laws that the Colonies had inher-
ited from England prevented the granting of cash loans
at economically feasible rates,, a legal instalment loan
market was, in essence, outlawed. Since the need for
small cash credit nonetheless existed, a flourishing illegal
market developed. “By 1900, almost every large city in
America had its loan companies, all operating illegally as
to the rate of interest and with the interest rates
covering a high and wide range . . . .” 3 The studies of the
Russell Sage Foundation disclosed that the rates of
charge of well over 200 percent per annum in the illegal
market were often accompanied by harsh collection
tactics. 4 As a result of those studies a model bill known
as the Uniform Small Loan Law was drafted to provide
an exception to the usury law so that consumers could
obtain small amounts of legal cash credit at conscionable
rates. Initially, the rate ceiling on small cash loans (up to
$300) was fixed at 42 percent per year.
The development of credit unions (1909) and Morris
Plan banks (1910) began shortly before the establish-
ment of licensed cash lenders. As will be seen later,
credit unions have become an increasingly important
source of credit for consumers. Morris Plan banks paved
the way for commercial banks to enter instalment
lending and became virtually indistinguishable from
those banks whenever they were given the privilege of
accepting demand deposits.
Reasons for growth of consumer credit
Between the ends of 1950 and 1971 , consumer credit
outstanding rose from $21 .5 billion to $137.2 billion, an
increase of over five times— and a compound annual rate
of growth of over nine percent. To give perspective to
this growth it may be noted that over the same period
outstanding nonfarm mortgages rose about five times,
corporate debt 4 1/2 times, and farm debt, about four
times. Primarily as a result of the slower rate of growth
of net public debt, which only doubled, consumer credit
grew from 4.4 percent to 6.9 percent of net public and
private debt between 1950 and 1971. The reasons for
this increased use of consumer Credit may be found in
the natural adaptation of consumer and business to
changes in the ability and willingness of consumers to
incur debt, as well as to a continued shift towards the
ownership of assets.
Characteristics of consumers. Consumers’ ability to
assume obligations to repay debts depends in part upon
the expected size and variability of their incomes. Of
particular influence is consumers’ “discretionary in-
come,” that is, the income over and above that required
for necessary expenditures on food, clothing, and
shelter. Although there is no universally acceptable
measure of its level, some indication of the dramatic
change that has occurred in the past 21 years may be
gained by observing shifts in family incomes in constant
5
dollars. Whereas not quite half the families in 1950 had
incomes of $5,000 or more in terms of 1971 dollars,
some 21 years later over four-fifths of families had such
incomes. The number of families with incomes of
$5,000 or more (1971 dollars) almost doubled from
23.2 million to over 43.5 million. 5 Not only was real
income higher, but it was also more stable as a result of
such developments as unemployment benefits and
various forms of health insurance.
Another factor that encouraged consumers’ use of
credit was the increased urbanization of the population.
Whereas over 1 5 percent of the total population was on
farms in 1950, less than 5 percent was in 1970. A greater
dependence on money incomes, coupled with the typical
needs of urban dwellers, probably contributed to a
greater dependence on credit, both to finance the urban
life and to cushion the variability in money incomes. It
should be noted, however, that the widespread availabil-
ity of television has probably brought a greater uniform-
ity in life styles among farm and urban consumers. Thus
their needs and desires for consumer credit probably
differ much less now than they did in the years prior to
1950.
The increased use of credit is also explained in part
by the changing age distribution of the population.
Young married consumers are heavy users of credit. At
that stage in their life cycle their needs exceed their
current incomes. Consumer credit permits them to pay
for purchases to meet such needs out of future income.
Between 1950 and 1971, the number of individuals aged
18 to 24 years grew from 18.6 million to 28.2 million. 6
In contrast to this 50 percent increase, the number of
individuals in all other age brackets grew by only 33
percent. During tills time many of these young people
were buying their first car, as well as their first crib and
playpen. The increased demand for credit was derived
primarily from the demands for goods and services by a
burgeoning crop of young Americans.
Willingness to incur debt. A need or demand for
credit does not necessarily lead to the granting of credit.
The increased willingness of consumers to use credit has
resulted from an interaction of consumer and credit
grantors. On the one hand, consumers became more
willing to use credit, in part as a result of their higher
and more stable incomes and in part because the growing
youthful portion of the population accepts credit as an
economic tool more readily than the older generation.
On the other hand, the credit industry responded to
consumers’ acceptance of credit by creating new and
often more useful forms of instalment credit. Thus
Wanamakers in Philadelphia pioneered the retailer’s
adoption of revolving charge accounts as early as 1938,
and the Franklin National Bank was the first to offer a
bank charge-card plan in New York in 1951 . Check-
credit plans were developed by the First National Bank
of Boston in the mid-1950’s to provide cash credit on a
revolving basis. These new forms of credit not only made
more credit available, but offered it more conveniently
on a continuing basis, thus obviating the need to reapply
for each extension of credit.
Shift to asset ownership. Consumers added substan-
tially to their ownership of durable consumer goods
through their use of credit during the past two decades.
The level of personal consumption expenditures on
durable goods almost tripled from 1950 to 1970, while
total expenditures were 3.2 times higher in 1970 than in
1950. However, it is necessary to keep in mind that
prices of durable goods have risen much less rapidly than
prices of nondurables and services. Over the 20-year
period prices of durable goods rose 26 percent; prices of
nondurable goods (excluding food) rose 48 percent; and
prices of services rose a thumping 107 percent. Conse-
quently, the relative extent to which consumers have
accumulated durable goods in real terms has been
obscured by the much greater inflation in prices of
nondurable goods and services.
An important reason for the shift to asset ownership
during the past two decades has been the increase in
ownership of homes-in themselves assets-although the
credit used to acquire homes is not counted statistically
as part of consumer credit. In large part as a result of
government support of housing, the percentage of
owner-occupied homes rose from 55 percent in 1950 to
over 64 percent in 1 970. Since home ownership was also
accompanied by a suburbanization of the population,
this trend brought with it needs for credit to purchase
the equipment necessary to suburban home owner-
ship-refrigerators, washing machines, lawn mowers,
playpools, and often, a second car. Within the last 11
years the proportion of households owning two or more
cars jumped from about 16 percent to just under 30
percent. 7
The shift to asset ownership also reflects a decision
by consumers to substitute the use of consumer-owned
capital goods for the use of commercially-owned capital
goods. Thus the purchase of an automobile substituted,
perhaps unfortunately, for daily fares on street cars and
buses, the home washing machine and dryer for pay-
ments at the laundromat, and the television set for the
admission price to movies and other forms of entertain-
ment. Even if the auto or appliance were purchased on
credit, the monthly instalments paid for it over a much
shorter interval than the period of time over which
services were received. In addition, quite often consum-
ers also gained significant returns on their investment. A
study prepared for the Commission shows annual rates
of return from ownership of a washer and dryer ranging
6
from 6.7 percent (three loads per week) to 29.0 percent
(seven loads per week). 8
Finally, the trend to asset ownership was aided by the
movement of women into the labor force. This shift, as
well as desires for increased leisure time, brought a
demand for labor-saving devices in the home. Freeing the
housewife from the kitchen and the laundry room for
recreation and employment thus increased the use of
credit for automatic dishwashers, self-timing ovens,
washers, dryers and other home appliances.
TYPES OF CONSUMER CREDIT
In reviewing statistics on consumer credit published
by the Board of Governors of the Federal Reserve
System (FRB) and relating them to issues in state and
Federal legislation governing consumer credit, one
should note some conceptual and definitional differ-
ences between the statistics and legislative coverage. The
data provided by FRB may then be classified into
instalment and noninstalment credit, as well as into the
subclassifications of each.
Statistical and legislative differences
The data on consumer credit provided by FRB
include “all short- and intermediate-term credit that is
extended through' regular business channels to finance
the purchase of commodities and services for personal
consumption, or to refinance debts incurred for such
purposes.” 9 However, a number of forms of credit not
included in the FRB data are covered by the Truth in
Lending Act (TIL) and the Uniform Consumer Credit
Code (UCCC). The FRB data do not include consumer
lease obligations, whereas TIL includes in the term
“credit sale” some contracts in the form of bailments
and leases. 1 0 The UCCC covers “consumer leases” wliich
have terms exceeding 4 months. 1 1
Both the TIL and UCCC include agricultural credit in
their coverage whereas this is excluded from the FRB’s
estimates as a form of business credit. Since the FRB’s
“commercial bank call report data on loans to farmers
do not segregate credit for consumption from that for
production purposes,” 12 some understatement probably
exists in the FRB’s statistics of credit received by
farmers for personal consumption and to refinance debts
incurred for such purposes .
FRB data do not include owner-occupied home
mortgages as a form of consumer credit, although credit
used to acquire mobile homes is covered. Borrowings
under “open-end” mortgages are not treated as a
component of consumer credit, even where used for
personal consumption. But home repair and moderniza-
tion loans are included. TIL and the UCCC apply to all
residential real estate credit extended to individuals for
disclosure and related debtors’ remedies. In order to
reach the high-rate, second mortgage without at the
same time covering home mortgages in general, the other
provisions of the UCCC apply to sales of interest in land
and loans primarily secured by an interest in land where
the finance charge exceeds 12 percent per annum. 1 3
In one respect the coverage of the FRB’s consumer
credit statistics is broader than that of TIL and the
UCCC. The FRB data Include consumer credit transac-
tions whether or not a finance charge is assessed, but
TIL classifies as consumer creditors only those “who
regularly extend, or arrange for the extension of, credit
for which the payment of a finance charge is re-
quired. . . .” 14 Since a finance charge is implicit in an
instalment credit transaction, regulation Z, which was
promulgated by FRB to implement the Truth in Lending
Act, clarifies the coverage by defining consumer credit as
credit “for wliich either a finance charge is or may be
imposed or which, pursuant to an agreement, is or may
be payable in more titan 4 instalments,” 15 However,
FRB data include credit scheduled to be repaid in two or
more payments. Finally, the UCCC covers consumer
credit sales that are repayable in instalments or for
which a credit service charge is made. 16 Thus the FRB
data include more consumer instalment credit than
covered by TIL in some instances but not in others. For
instalment credit, the coverage of the FRB and the
UCCC is unaffected by the presence or absence of a
finance charge. For noninstalment credit— such as the
30-day charge account and gasoline credit card-data
from the FRB include outstandings not covered by
either TIL or the UCCC.
Instalment versus noninstalment credit
The FRB’s data on consumer credit are first divided
between instalment and noninstalment credit. As noted
earlier, instalment credit includes all consumer credit
scheduled to be repaid in two or more payments.
Consumer credit scheduled to be repaid as a single, lump
sum is classified as noninstalment credit. The major
classification problem in this area is the treatment of
retailers’ revolving charge accounts. When a consumer
exercises his option to pay his account within the “grace
period” and thereby avoids a finance charge, he is really
treating the account as if it were a traditional 30-day
charge account. Although the 30-day charge account is
clearly noninstalment credit, the statistical problems of
correctly identifying the “noninstalment” portion of
revolving charge accounts have forced the FRB to
496-072 0 - 73 -3
7
classify the balance in all such accounts as instalment
credit.
Instalment credit comprised four-fifths of consumer
credit outstanding at the end of 1970. Over the past two
decades instalment credit has grown much more rapidly
than noninstalment credit (Exhibit 2-1). Instalment
credit outstanding rose by 5.9 times, and noninstalment
credit only 2.8 times. The more rapid expansion of
instalment credit reflects primarily the shift to asset
ownership-the purchase of consumer durables— which is
financed more by instalment than by noninstalment
credit.
During this period consumer instalment credit out-
standing rose more rapidly than monthly payments.
While outstanding consumer instalment credit rose by
5,9 times, the annual level of repayments rose by only
4.5 times. This occurred because of the longer maturities
that became available, particularly on automobile credit
and to some extent on personal loans. A much smaller
portion of the differential in growth rates is attributable
to the development of various forms of revolving credit
which substituted in some measure for noninstalment
credit .
Classes of instalment credit. The four classes of
instalment credit are automobile paper, other consumer
goods paper, home repair and modernization loans, and
personal loans (Exhibit 2-2). The largest and most
volatile portion of consumer instalment credit is auto-
mobile credit, which accounted for about 35 percent of
the total outstanding at the end of 1970. Automobile
credit includes credit extended for the purchase of both
new and used automobiles; other consumer goods paper
represents credit extended for the acquisition of such
consumer goods as home appliances, boats, and mobile
homes. Repair and modernization loans, which have
grown only moderately, include both FHA-insured
credit and noninsured credit extended to consumers for
the maintenance and improvement of their homes. Many
personal loans are made to refinance existing debts,
while others are used to meet medical, travel, and
educational expenses. Undoubtedly some personal loans
are used to acquire automobiles and other consumer
goods, and to repair and modernize homes, Because the
lender does not always know the intended purpose of
the loans, some overstatement of personal loans out-
standing is likely with a corresponding understatement
of outstanding? in the other three categories of con-
sumer instalment credit.
Gasses of noninstalment credit. The components of
noninstalment credit are single -payment loans, nonre-
volving charge accounts, and service credit. Most single-
payment loans are extended by commercial banks. The
charge-account segment includes primarily the tradi-
tional 30-day charge accounts of retailers, as well as
amounts owed on gasoline credit cards, home heating-oil
accounts, and other credit -card accounts. The most
important component of service credit is debt to doctors
and hospitals; a smaller portion is owed to public
utilities and other service establishments. Single-payment
loans have been the most rapidly growing portion of
noninstalment credit.
Holders of consumer credit
FRB classifies amounts of consumer credit outstand-
ing by holder- rather than by originator. For example, a
significant portion of automobile paper is originated by
dealers at the point of sale and subsequently sold to
banks or finance companies. In such cases the banks and
finance companies are classified as the holders of the
paper, because they supply the credit.
At the end of 1970, some 13,600 commercial banks
held just over $50 billion of consumer credit outstand-
ing, or almost two-fifths of total outstanding?. Their
holdings of consumer instalment credit have grown
rapidly in the past 20 years (Exhibit 2-3), although, not
as rapidly as those of credit unions. Between 1950 and
1970 commercial banks increased their market share of
consumer instalment credit by only two percentage
points (Exhibit 2-4). In recent years their growth has
been stimulated by the development of bank credit
cards, but outstandings on credit cards were still only
about 9 percent of banks’ holding of instalment credit
at June 30, 1971.
Finance companies for the most part purchase instal-
ment paper arising from retail sales of consumer durables
and make cash loans. Until 1971, sales finance and
personal finance companies were classified separately by
the FRB. However, the distinction between the two has
become blurred in recent years as each type of concern
has diversified its consumer credit activities. Also,
unattractive returns from consumer credit have caused
several major firms to divert their resources into noncon-
sumer credit investments. At mid-1965, about 3,700
finance companies were operating in the United
States. 17 This figure, however, greatly understates the
competitive impact of these firms, since many had
numerous offices. Assuming the same ratio of firms to
offices that prevailed in 1960, the number of offices of
finance companies would-be estimated to be between
13,000 and 14,000.
Adding to competition in the market for consumer
credit were some 23,656 credit unions. 18 The effective-
ness of their competition is shown in Exhibit 2-4.
Between 1950 and 1970 they more than tripled their
share of the market, largely at the expense of finance
companies and retail outlets. Credit unions, as coopera-
tives, are not subject to state or Federal income taxes.
Many firms provide the credit unions serving their
8
EXHIBIT 2 - 1
CONSUMER INSTALMENT AND NONINSTALMENT
CREDIT OUTSTANDING, 1939-1970
Billions of Dollars Billions of Dollars
2
EXHIBIT 2 - 2
GROWTH IN MAJOR TYPES OF CONSUMER INSTALMENT CREDIT
1939-1970
EXHIBIT 2 - 3
INSTALMENT CREDIT OUTSTANDING BY HOLDER
1939-1970
♦Not including charge accounts.
SOURCE: National Commission on Consumer Finance based on FRB data.
10
EXHIBIT 2-4
CHANGES IN HOLDINGS OF CONSUMER INSTALMENT CREDIT BY TYPE OF HOLDER,
1950-1970
Amounts outstanding
(Dollar amounts in millions)
December, 1950
December, 1970
Amount
Commercial banks $5,798
Finance companies 6,315
Credit unions 590
Miscellaneous 3 •••• • 102
Retail outlets 2,898
Totals . $14,703
Percent
39.4
Amount
$41,895
Percent
41.4
36.1
31,123
30.8
4.0
12,600
12.4
0.7
1,646
1.5
19.7
. 14,097
13.9
100.0
$101,161
100.0
Miscellaneous lenders include savings and loan associations and mutual savings banks.
Details may not add to totals because of rounding.
Source: Board of Governors of the Federal Reserve System.
employees with office space and equipment at no
charge, and many employees contribute their time.
Credit unions’ lower operating costs and freedom from
taxes are transmitted to their members in the form of
higher dividends and lower credit charges than provided
by many competing credit grantors.
Retail outlets provide the other major source of
credit to consumers. They are probably the most
numerous credit grantors, although reliable data on the
number of firms are not available. Even though retailers
shifted some portion of their outstandings from charge
accounts to revolving credit, their share of instalment
credit outstanding declined from almost 20 percent to
less than 14 percent between 1950 and 1970. 19 Their
share of noninstalment credit declined even more, from
almost half in 1950 to just over one-fourth in 1970,
The existence of many competing credit grantors is
essential to providing consumers with adequate amounts
of credit at reasonable rates. The very large number of
credit grantors in the United States suggests that
considerable competition is very likely to be found in
the market for consumer credit. To evaluate the extent
of competition properly it is important to understand
that for the most part there is no national market for
consumer credit. Consumers seldom shop for credit
outside their town or city, although there is some mail
order business, especially in the retail field, and consider-
able borrowing against cash reserves of life insurance
policies. But generally, the market for consumer credit is
fairly restricted geographically. Perusal of telephone
book ‘Yellow pages” of most cities discloses many
competing credit grantors— commercial banks, finance
companies, savings and loan associations, industrial
banks and loan companies, credit unions, savings banks,
and retailers. The competitive nature of these markets is
increased where credit grantors have ease of entry into
the market and is hampered where restrictive licensing
provisions and legal rate ceilings baT the entry of some
creditors into the market for higher-risk borrowers.
The generally competitive nature of most markets for
consumer credit should not, however, obscure the fact
that competition in some markets is probably not
entirely effective. Competition is less likely to be
effective where markets are highly concentrated— where
the largest firms have a commanding share of the
market. Also, there is less competition when there are
fewer competitors, e.g., in small, so-called, “one-bank”
towns and in some areas of the inner cities populated by
low income consumers. This report contains recom-
mendations in later chapters for lowering concentration
in markets and providing more alternatives for consum-
ers seeking credit.
The changing market shares of various types of
consumer instalment credit by the various holders of
1 )
that credit are shown in Exhibit 2-5. Commercial banks
clearly have assumed a dominant role in the instalment
financing of automobiles, holding over 56 percent of
total outstandings at the end of 1970. Credit unions
have become increasingly important in the automobile
loan field. A study of the purpose of loans made by
Federal credit unions in 1971 shows that more than 30
percent of the amount of loans made were to finance the
purchase of new and used cars. 20
Retailers’ share of other consumer goods instalment
credit has declined, while that of sales finance companies
has increased over the past two decades. This shift is
explained in part by the formation of finance subsidiar-
ies by a number of large manufacturers and retailers, as
well as by the increased financing of mobile homes by
sales finance companies. There was also a transfer of
holdings from retailers to banks. The share of other
consumer goods paper held by commercial banks has
risen sharply in the past few years because of the
accelerated introduction of bank credit cards. At the end
of 1967, 390 banks reported holding some $800 million
under credit-card plans. But just 3 years later over 1,200
banks reported outstandings on credit cards of $3.8
billion. 2 1
Although commercial banks dominate the market,
they have held a declining share of home repair and
modernization loans outstanding over the past 20 years
(Exhibit 2-5). Credit unions and other financial lenders
(excluding finance companies) have increased their share
of home repair and modernization loans. During 1971,
more than 8 percent of the amount of loans extended by
Federal credit unions were for home repair and mod-
ernization. 2 2
The Commission conducted a survey of the major
suppliers of consumer instalment credit at mid-1971 in
which all such credit then outstanding was classified in
seven categories. The results of that survey are summa-
rized in Exhibit 2-6. Commercial banks held the largest
portion of outstandings in four of the seven categories
and ranked second in the other three. Finance compa-
nies’ personal loans outstanding exceeded those of
commercial banks, and retailers held more revolving
credit and other consumer' goods paper than did com-
mercial banks.
In the same survey, the Commission gathered data on
average customer rates of charge on major types of
consumer instalment credit extended, and classified
those responses by source. Exhibit 2-7 summarizes
average rates charged by commercial banks, mutual
savings banks and retailers on typical transactions. For
finance companies, - ' the survey sampled actual contracts,
and those results are summarized in Exhibit 2-8.
USERS OF CONSUMER CREDIT
As indicated earlier, consumers use credit, not for its
own sake, but because they wish to acquire goods and
services. Therefore, consumers making above-average use
of credit could be expected to be those whose need for
goods and services exceed immediately available current
income, This general hypothesis is supported by the data
in Exhibit 2-9.
With respect to income, families who used credit
most frequently in 1971 were those with annual family
incomes before taxes of $7,500 to $15,000. Families
with incomes of less than $5,000, especially less than
$3,000, used instalment credit much less frequently.
Either they exercised self-restraint, or credit grantors
were unwilling to extend them credit . The frequency of
use of instalment credit also declined among families
with incomes above $15,000. Some of these families
may have used consumer credit, but in the form of
single-payment loans from commercial banks or life
insurance company policy loans-types of credit not
covered by the survey data. Others probably did not
require credit because of their wealth.
The need to use credit because of the stage in the
family life cycle is clearly demonstrated in Part B of
Exhibit 2-9. Young married couples with children were
the most frequent users of consumer instalment credit;
about seven-tenths had instalment debts. When the
family head was age 45 or older, instalment credit was
used by three-fifths of the families when children were
present, by about one-third when the head of household
was working and no children were at home, and by
about one-sixth when the head of household was retired
and no children were at home.
The frequency of instalment credit use in relation to
the age of the family head is, of course, intimately
related to the level of income and stage in the life cycle
characteristic of that age. Those in the younger age
groups shown in Part C of Exhibit 2-9 used instalment
credit most frequently. A significant decline in fre-
quency of use did not occur until after age 55.
The profile that emerges is that the consumer most
likely to employ instalment credit to acquire goods and
services is young, married, with children at home and
with a family income between $7,500 and $15,000. The
stage in the life cycle of the family appears to be most
influential in determining frequency of use, while the
level of income probably has a greater influence on the
quantity of debt and the quality of the goods and
services acquired.
12
EXHIBIT 2 - 5
HOLDERS OF AUTOMOBILE INSTALMENT
INSTALMENT CREDIT, 1939-1970
Pflicent P«rc»nt
HOLDERS OF PERSONAL LOANS,
1939-1970
HOLDERS OF REPAIR AND MODERNIZATION
CREDIT, 1939-1970
n I ' Porran)
13
EXHIBIT 2-6
CONSUMER INSTALMENT CREDIT BY MAJOR TYPE AND MAJOR SOURCE, JUNE 30, 1971
(in billions of dollars)
Note: Data may not add to totals because of rou riding.
a Excludes credit held by savings and loan associations,
b Less than .05,
Source: National Commission on Consumer Finance, Survey of Consumer Credit Volume, Second Calendar Quarter, 1971, and Consumer Credit Outstanding, June 30, 1971 .
EXHIBIT 2-7
AVERAGE CUSTOMER ANNUAL PERCENTAGE RATES OF CHARGE ON SELECTED
TRANSACTIONS WITH COMMERCIAL BANKS, MUTUAL SAVINGS BANKS AND
RETAIL OUTLETS
JUNE 30, 1971
Typical Customer APR 3 Charged by
Type of Credit
Mutual Savings
Commercial Banks Banks Retail Outlets
New Automobile, $3,000, 36 months
Direct loan
10.08
9.92
a a.
Purchased paper
12.10
n.a.
n.a.
Mobile Home, $7,000, 72 months
Direct loan
10.87
11.70
n.a.
Purchased paper
12.12
n.a.
n.a.
Home Repair and Modernization, $2,500, 60 months.
non-FHA
Direct loan
11.57
11.39
n.a.
Purchased paper
12.09
n.a.
n.a.
Other Consumer Goods
Direct, $100, 12 months
n.r.
n.r.
17.90
Direct, $300, 24 months
n.r.
n.r.
17.89
Purchased Paper, $500, 24 months
15.89
n.a.
n.a.
Personal Loans, Unsecured
$1,000, 12 months
12.76
12,52
n.a.
$1,000, 24 months
12.87
12,34
n.a,
Credit Card Plans
$100 merchandise balance
18.00
n.a.
(b)
$100 cash advance balance
17.30
n.a.
n.a.
Notes: n.a. indicates "not applicable."
n.r. indicates data "not reported."
a Medlan of state mean APR's.
^Because of system of graduated rates used In soma states,
average rates were not computed.
Source: National Commission on Consumer Finance, Survey of Consumer Credit Volume, Second Calendar Quarter, 1971 and
Consumer Credit Outstanding, June 30, 1971.
EXHIBIT 2-8
AVERAGE CUSTOMER ANNUAL PERCENTAGE RATE OF CHARGE, AMOUNT FINANCED,
AND MATURITY FOR SELECTED TYPES OF CREDIT EXTENDED BY FINANCE COMPANIES
BETWEEN JUNE 17 AND JUNE 30,
, 1971
Amount Financed 3
- - ■
Customer APR 3
per Contract
Maturity 3
Type of Credit
(%)
( dollars )
( months )
New Automobile, purchased paper
12.33
3,048
34.47
Other Consumer Goods, purchased paper
20.37
334
17.87
Personal Loans
25.80
958
26.02
a Median of state means.
Source: National Commission on Consumer Finance, Survey of Consumer Credit Volume, Second Calendar Quarter, 1971, and
Consumer Credit Outstanding, June 30, 1971.
15
EXHIBIT 2-9
DEMOGRAPHIC CHARACTERISTICS OF FAMILIES WITH CONSUMER
INSTALMENT DEBT, EARLY 1971
Percentage having
A. By annual family income instalment debt
Less than $3,000 29
$3,000 - 4,999 39
$5,000-7,499 51
$7,500 - 9,999 53
$10,000- 14,999 .. 60
$15,000 or more 46
All families 48
B. By life cycle stage of family head
Under age 45:
Unmarried, no children 41
Married, no children 66
Married, youngest child under 6 68
Married, youngest child age 6 or older 70
\
Age 45 or older:
Married, has children ". 60
Married, no children, head in labor force 34
Married, no children, head retired 16
Unmarried, no children, head in labor force 34
Unmarried, no children, head retired 12
Any age, unmarried, with children 63
All families 48
C. By age of family head
Under age 25 66
25-34 67
35-44 62
45-54....... 51
55-64 .36
65-74 18
75 or older 8
All families 48
Source: 1971 Survey of Consumer Finances, (Ann Arbor, Michigan: Survey Research Center, University of Michigan,
August 1971), Statistical Report 2, Table 2-3.
16
IS CREDIT USED EXCESSIVELY?
The desire of credit grantors to provide credit and the
eagerness of consumers to acquire goods and services
financed with credit may, indeed, lead consumers to use
credit to excess. But, forces operate to counteract
over-reliance on credit. First, most suppliers hesitate to
grant credit if they doubt that the consumer can repay.
Every extension of credit represents a bet in a sense, and
as the consumer becomes progressively burdened with
debt, the odds against repayment increase, and the
likelihood that the creditor will accept the applicant
decreases. Availability of collection remedies also influ-
ences the chances of collection (see Chapter 3). Second,
most consumers hesitate to assume obligations they
cannot repay. Surveys show that consumers are generally
aware of the monthly payments required on instalment
purchases— an indication of their concern about fitting
instalment credit obligations into their budgets. To
measure the effectiveness of these two constraints on the
excessive use of credit the Commission examined the
adequacy of consumers’ incomes to meet repayment
obligations, the balance sheet position of consumers,
and, finally, evidence concerning problems consumers
have faced in repaying their debts. On the fringe of the
market, there may be marginal suppliers of credit who
encourage marginal borrowers who cannot obtain credit
elsewhere to become overextended. Part of this fringe
exists in the legal market where credit is primarily a
means of selling low quality goods at high prices, and
part is in the illegal market where credit is provided at
rates far above legal ceilings. Because many of the data
examined are aggregates, many of the conclusions about
overindebtedness are drawn from analysis of the con-
sumer sector as a whole.
Repayments and disposable personal income
To measure the burden of consumer credit it is useful
to compare annual repayments on consumer instalment
credit to disposable personal income-that is, the per-
sonal income available to consumers after personal tax
and nontax payments to governments. The comparison
Is analogous to a measure of coverage of fixed charges
used to assess the ability of a business firm to carry its
debts. After a rise in the 1950’s, the ratio of annual
instalment repayments to disposable personal income
stabilized in the range of 14.5 to 15.0 percent (Exhibit
2-10). During the 5-year period, 1967-1971, payments
never exceeded 15.0 percent of disposable personal
income and never fell below 14.7 percent.
EXHIBIT 2-10
Instalment Credit Repayments as a
Percentage of Disposable
Personal Income
(Seasonally Adjusted)
Percent
1965 - 14,7
1966- 14.9
1967 - 14.9
1968 15,0
1969- 15.0
1970- 14.8
1971 - 14.7
Source: Board of Governors of the Federal Reserve System
Percent
1929-6.4
1939- 8.6
1949-8.2
1955- 12.2
1960- 13.1
1964- 14.5
Because the ratio of repayments to disposable per-
sonal income is purely an aggregate measure, it is useful
to examine data showing the dispersion of the ratios of
annual payments on instalment debt to disposable
income (Exhibit 2-1 1). No statistically significant change
is evident in the proportion of families having payments
on instalment debt amounting to 10 percent or more of
disposable Income in the previous year, Some reduction
in the relation of payments to income in 1970 was
probably induced by the recession that year. The slight
change in the 5-to-9 percent category is probably not
significant except for 1970 and 1971. In short, the
dispersion of payments in relation to disposable personal
income remained steady for the 7-year period and
suggests no material change in the willingness and ability
of consumers to assume obligations to repay debt from
anticipated disposable personal income.
While the ratio of repayments on consumer instal-
ment credit to disposable personal income may appear
to be a useful target for “prudent” family money
management, the wide dispersion in the ratio among
families contradicts any such simplistic approach. In-
come is not the only determinant of a family’s level of
debt. The number and ages of actual and potential
dependents, the stability of the wage earner’s employ-
ment, the health of the family, and its liquid assets
holdings are only a few of the many factors that bear on
a family’s ability to carry consumer debt. In addition,
Exhibit 2-1 1 shows only payments on consumer instal-
ment debt and omits other required disbursements, such
as rental or mortgage payments, and payments on
noninstalment consumer credit, such as 30-day charge
accounts.
17
EXHIBIT 2-11
RATIO OF ANNUAL INSTALMENT DEBT PAYMENT TO PREVIOUS YEAR'S
DISPOSABLE INCOME
Ratio Proportion of families
1965
1966
1967
1968
1969
1970
1971
None
51
51
52
52
49
51
52
1 to 4 percent
8
7
7
7
6
12
13
5 to 9 percent
11
13
12
14
15
15
13
10 to 19 percent
17
18
19
18
19
14
13
20 to 39 percent
9
8
7
7
8
5
5
40 percent or more 3 . .
1
1
2
2
3
1
2
Not ascertained
3
2
1
'
2
2
100
100
100
100
100
100
100
a Includes families with zero or negative disposable income.
Source: George Katona, W. Dunkelberg, G. Hendricks, and J. Schmiedeskamp, 1969 Survey of Consumer Finances (Ann Arbor, Mich.:
Survey Research Center, University of Michigan, 1970), p. 21; George Katona, Lewis Mandell, and J. Schmiedeskamp, 1970
Survey of Consumer Finances (Ann Arbor, Mich.: Survey Research Center, University of Michigan, 1971), p. 25; 1971 Survey
of Consumer Finances, (Ann Arbor, Mich.: Survey Research Center, University of Michigan, August 1971), Statistical Report
2, Table 2-4,
Even if these and other significant economic and
demographic factors could somehow be reflected in a
model for the “proper” levels of debt for a family, there
would be no allowance for differences in life style
among families. Each family has a unique value system
under which it allocates resources among goods and
services, both for present and for future consumption.
Thus a financial yardstick representing an average family
will not serve a specific family. At best, it can only warn
of extreme levels of debt.
Balance sheet position
In determining the ability of a business firm to
•assume debt, financial analysts commonly use two
measures. The first relates repayment obligations to
income, a test of the sort just applied to consumers’
instalment debt. The second measure, derived from the
firm’s balance sheet, may take the form of the ratio of
current assets to current liabilities (the “current ratio”)
or of the ratio of debt to net worth. To some extent these
balance sheet tests can be applied to consumers’ debts.
The data in Exhibit 2-1 2 demonstrate the very liquid
position of consumers at the end of 1971. Although in
the aggregate consumers had more than enough in their
savings deposits to repay outstanding home mortgages
and consumer credit obligations, this was not true of all
individual consumers. Nonetheless, tire overall picture is
one of strength, because most of the financial assets
could be liquidated into immediate cash, whereas many
of the debts extend over several years (particularly home
mortgages). Not shown in the table are the fixed assets
of consumers— their homes and the various consumer
durables whose purchase was facilitated by the liabilities
listed in the table. Also not shown in the national
accounts are nontangible assets such as education, often
financed by credit. If these data were available, the ratio
of debt to net worth of American consumers would be
negligible .
Even though aggregate data suggest that credit grant-
ors and consumers have been cautious in arranging
obligations, some individual consumers have problems
repaying their debts. At the extreme these problems
result in bankruptcy. In the early 1960’s the rate of
nonbusiness bankruptcies per 100,000 of population
rose from 73 to 85 (Exhibit 2-13). Since 1965, the rate
seems to have stabilized with the exception of 1967
when nonbusiness bankruptcies reached 98 per 100,000
population.
Problems in repaying debt
18
EXHIBIT 2-12
BALANCE SHEET POSITION OF CONSUMERSa AT YEAR-END 1971
(In billions of dollars)
Financial Assets
Demand deposits and currency $1 34.9
Savings accounts 496.0
Corporate shares 878.6
Other credit market instruments 224.9
Life insurance reserves 137.0
Pension fund reserves 268.1
Miscellaneous assets 30.9
Total financial assets $2,170.4.
Total Liabilities
Credit market instruments:
Home mortgages
Other mortgages ........
Consumer instalment credit
Other consumer credit. . . .
Bank loans (other).
Other loans
$296.1
21.9
109.5
27.7
25.8
22.2 $503.2
Security credit, trade credit and other
22.6
Total liabilities $525.8
households, personal trusts, and nonprofit organizations.
Source: Federal Reserve Bulletin, 58 (June 1972), p. A73.15.
EXHIBIT 2-13
Nonbusiness Bankruptcies per
100,000 of Population
(Fiscal year ending in June)
1961 -73 1966-91
1962- 72 1967-98
1963- 75 1968-92
1964- 82 1969-85
1965- 85 1970 -88
1971-88
Source: Based on data contained in Annual Report of the
Director of the Administrative Office of the United
States Courts, 1971 (Washington, D.C,: U.S. Govern-
ment Printing Office, 1972) pp. 227-238, 381-392.
The number of nonbusiness bankruptcies relative to
population varied greatly among states. For example, for
the fiscal year ending June 30, 1971, the number of
nonbusiness bankruptcies (including Chapter XIII of the
Bankruptcy Act) per 100,000 of population in a sample
of states ranged as follows: 23
Nevada
264
Texas
14
Alabama
260
New Jersey
13
Kansas
195
Maryland
12
Tennessee
189
Pennsylvania
" 12
Oregon
179
South Carolina
8
An earlier study, based on the 1960 Survey of
Consumer Finances, attempted to identify the character-
istics of consumers who have excessive instalment debt
and sought an .economic explanation for excessive
indebtedness. 24 Ryan and Maynes classified excessive
indebtedness into two categories: families in “some
trouble” and “deep trouble.” After eliminating for
technical reasons 194 of the 1417 families in the sample
19
with some instalment debt, the researchers found 39
percent of the remaining families with debt in “some
trouble,” and, within this group, 11 percent in “deep
trouble.” The classification system was based on these
assumptions :
1. The greater the debt payments-to-income ratio,
the greater the probability that a family’s debt
1 position will lead to “trouble.”
2. If a family’s liquid assets minus a “transactions
balance” of $200 exceeds outstanding instalment
debt, instalment debt owing will pose no trouble.
3. The higher a family’s income, other factors being
constant, the greater the debt payments-to-income
ratio it can sustain without encountering trouble.
Ryan and Maynes noted the following with respect to
personal characteristics of the overindebted.
“The greatest proportions of debtors in trouble were
found among the unmarried (especially tire separated,
divorced, and widowed), the poor, and those under
25 or 65 years and older .... About 40 percent of
single-person households and Negro households were,
by our definitions, in deep trouble. . . . Households
headed by women were more likely to be headed for
debt troubles. . . . Education (given its correlate,
income) was inversely related to debt trouble.
Also. . .families with children are those least likely to
be in trouble due to instalment debt. And conversely,
households without children— at both extremes of the
life cycle-are more likely to be in trouble. ... the
longer a household head has been married, the less
likely that it is in debt trouble.” 2 5
The economic characteristics of the overindebted
were related to the lack of full-time participation in the
EXHIBIT 2-14
WHETHER FAMILIES MADE MONTHLY PAYMENTS AS SCHEDULED IN 1968
(Percentage distribution of families with debt or mortgage payments)
Both— "got
Paid faster behind" and
Paid as or larger "faster or NA
scheduled amounts larger" Got behind DK a Total
All families with payments
1968
71
13
3
7
6
100
1967
71
12
3
7
7
100
Annual disposable family income
Less than $3,000
62
7
1
17
13
100
$3,000-$4,999
72
4
4
11
9
100
$5,000-$7,499
74
8
3
10
5
100
$7,500-$9,999
68
17
4
8
3
100
$10,000-$ 14,999
72
16
4
4
4
100
$15,000 or more
77
15
1
1
6
100
Ratio of annual instalment debt
payments to disposable income
Less than 5 percent
74
13
1
5
7
100
5-9 percent
73
14
3
6
4
100
10-19 percent
69
13
4
9
5
100
20-39 percent
67
11
6
10
6
100
40 percent or more
74
9
2
9
6
100
a Not ascertained, don't know.
Source: George Katona, Lewis Mandell and J. Schmiedeskamp, 1970 Survey of Consumer Finances (Ann Arbor, Michigan: Survey
Research Center, University of Michigan, 1971), p. 33.
20
labor force, residence outside of major metropolitan
areas, as well as residence in the South. Home-
owner-debtors were less likely to be in “trouble” than
other debtors.
Additional evidence of possible excessive acquisitions
of debts by consumers is available in the 1969 Survey of
Consumer Finances. About 10.5 percent of the families
with debt payments reported rescheduling debt pay-
ments during 1968. This amounted to 5.4 percent of all
families. 26
Exhibit 2-14 shows that families with low incomes
were more likely to get behind in their payments than
families with high incomes, hardly an unexpected result.
Among those with incomes above $7,500 about one-
sixth paid faster than required by contract. Interestingly
enough, one-fifth of those with very small debts (less
than $100) reported that they got behind, whereas only
one-tenth paid faster than required. As shown in the
lower part of Exhibit 2-14 the proportions of “slow-
payers” and “fast-payers” were about the same for
families whose instalment payments exceeded 20 per-
cent of their annual disposable family income. This
result suggests that relatively high ratios of debt repay-
ments to income are not a sure portent of trouble , as
often alleged, but may also indicate a greater ability to
incur and carry debt.
Conclusion
Consumer credit has been an economic fact of life
since Colonial days. The rapid growth of consumer
credit in the United States has in large part been a
natural accompaniment to the growth of other forms of
debt, both public and private. At the end of 1971,
consumer credit still amounted to somewhat less than 7
percent of net public and private debt. Consumers’ use
of credit has been encouraged by their rising discretion-
ary income, the urbanization of the population, and the
influx of younger consumers into the market. A
particularly important influence has been the trend to
homeownership and its accompanying shift to owned
durable goods in substitution for purchased services. The
growth of asset ownership has also been stimulated by
the increased number of women in the work force.
The result of these social and economic developments
has been the creation of $137.2 billion of consumer
credit as of the end of 1971. This credit has been
classified by the Federal Reserve Board into noninstal-
ment and instalment credit, the latter being by far the
larger portion. Each of these two classes is further
segmented according to the purpose for which the credit
was granted. To the extent possible, each of these two
classes is further segmented according to the purpose for
which the credit was granted. The amounts of credit
outstanding are also classified according to the financial
institution or other business that holds the receivables.
Except for personal loans and other consumer goods
credit, commercial banks are the largest holders of each
sub-class of instalment credit and of single-payment cash
loans. Credit unions have shown the most rapid growth
in their holdings of consumer instalment credit over the
past two decades. Within just the past 3 years, out-
standings generated by bank credit cards have shown the
greatest rate of growth.
In spite of the increase in outstanding consumer
credit, analysis of aggregate data does not indicate a
dangerous situation of overindebtedness. Although a
small portion of consumers resort to bankruptcy each
year, most consumers appear to be able and willing to
meet their obligations; in fact, the families who pay in
advance of scheduled maturities seem to outnumber
those who fall behind in their payments. The remaining
chapters will explore in much greater detail the ade-
quacy of the consumer credit markets to serve the
American consumer, including the underprivileged in our
society.
21
Chapter 3
CREDITORS’ REMEDIES AND CONTRACT PROVISIONS
INTRODUCTION
One of the most controversial areas in consumer
credit is that of creditors’ remedies. Any discussion of
modification or abolition of some creditors’ remedies
and clauses included in most consumer credit contracts
is accompanied almost axiomatically by impassioned
argument in defense of the status quo or in behalf of
change. Such discussions are usually permeated with a
fervid intolerance for contrary opinion -an attitude
common to consumer groups and creditors alike. Past
attempts at modification, restriction, or abolition of
certain creditors’ remedies and certain clauses in con-
sumer credit contracts have been subjected to criticism
and dissatisfaction and to charges of “too little too
late,” “overly protective of the consumer,” and
“paternalistic.”
Against this theoretical background the Commission
examined the subject of creditors’ remedies and contract
provisions as part of its inquiry into “The adequacy of
existing supervisory and regulatory mechanisms to pro-
tect the public from unfair practices.”
Traditionally consumer credit legislation has focused
on specific problem areas or areas of abuse with the idea
of correction, modification, or outright change. Little
attention has been paid to the effect and impact such
legislation might have on the availability of consumer
credit and on the consumer credit market. Most con-
sumer credit legislation has been passed without recog-
nition of its effect on the rate of charge and availability
of credit to consumers. So the Commission compiled
and analyzed as much relevant data as possible on the
use of various creditors’ remedies and contract pro-
visions so that its recommendations would fully reflect
the probable impact of any recommendations for
change.
In June 1970 at a hearing on debt collection practices
the Commission heard many witnesses, some of them
attorneys directly involved in the collection process,
relate their experiences with abusive debt collection
activities. A number urged curtailment or prohibition of
several debt collection practices, creditors’ remedies, and
consumer credit contract clauses because of harsh effects
resulting from their abuse.
Because restricting or abolishing certain collection
devices and remedies would probably have direct effects
on credit grantors as well as users, the Commission felt
obligated to consider industry views, too.
Believing that further public hearings to gather
industry opinion might fail to afford all industry
segments— large and small, single state and multistate
operators— an equal opportunity, the Commission con-
cluded that the best way to ascertain the full impact of
curtailing or restricting remedies was to survey' parts of
industry.
Collection Practices and Creditors’ Remedies Survey
(hereinafter, Survey ) data together with results from
another state-by-state survey of major types of consumer
credit extended and outstanding and their average rates
of charge gave the Commission a factual basis for
estimating probable effects if certain collection prac-
tices, creditors’ remedies, and contract provisions were
restricted or abolished. Resultant recommendations
recognize the need to achieve and maintain a fair balance
of rights and duties between creditor and debtor in
consumer credit transactions.
Survey results indicated that most creditors thought
debtors failed to meet their contractual obligations
because they became unemployed, ill, or overextended
after incurring the debt, not because they were “dead-
beats” who never intended to repay. Still, creditors
overwhelmingly preferred that the full panoply of
remedies be available as collection tools.
Few states place restrictions on all the methods by
which creditors can collect past due obligations. It has
been traditional for limitations on methods of collection
to be left for the parties to work out in the contract. But
the time has come to recognize that in consumer credit
transactions the creditor’s ability to use a full range of
collection devices is not a matter for creditor-debtor
negotiation but a set of contractual conditions imposed
by the creditor on “a take-it-or-leave-it basis.” 1 The
disparity in bargaining power between creditor and
debtor in consumer transactions is a fact of the
marketplace which has been recently recognized by
several Federal and state court decisions 2 as well as by a
British Committee which studied consumer credit. 3 The
standard form contract, with provisions drawn almost
496-072 0 - 73-4
23
entirely from the creditor’s standpoint, is further evi-
dence of inequality of bargaining power. 4
A step necessary to help equalize the positions of
participants in the consumer credit market is to restrict
or abolish those creditors’ remedies and collection
practices which, in view of the major reasons for default,
are likely to cause undue hardship, Under existing rate
structures and legal restraints on new entry into certain
consumer credit markets (Chapters 6 and 7), any
abolition or restriction of creditors’ remedies or collec-
tion practices may result in reduced credit availability or
higher rates, or both, to segments of the consuming
public. Thorough analysis of Commission Survey find-
ings support this hypothesis. Nonetheless on public
policy grounds the Commission believes that abolition or
restriction of some creditors’ remedies and collection
practices is in the best interest of the public, generally.
While recognizing the need for more balanced legislation,
the Commission realizes that creditors, too, have rights
and are entitled to legal protections. Its recommenda-
tions for legislation concerning remedies and contracts
are intended to afford debtor-consumers protections
they cannot obtain through bargaining and still to give
creditors the tools they need to collect just debts.
Recommendations regarding remedies are inextri-
cably interwoven with Commission recommendations on
rates and availability (Chapters 6 and 7). It is imperative
that the relationship be realistically assessed— the higher
the rate tire fewer the remedies needed and vice versa.
States may decide to narrow or broaden Commission
recommendations on remedies and contract provisions.
But they should recognize that modifications are likely
to affect the cost and availability of consumer credit.
Contract Provisions and Creditors’ Remedies
Contract Provisions
Acceleration Clauses - Default -Cure of Default
Acceleration clauses in consumer credit contracts— for
both cash and sale credit-are provisions “by which the
time for payment of the debt is hastened or advanced
because of the breach of some condition of the contract
by the debtor.” 3 Under the Uniform Commercial Code
(hereinafter, Code) the creditor may accelerate payment
(hold the entire debt, including future instalments, due
and payable) upon default 6 by the debtor or some
contract provision or (‘when the creditor deems himself
insecure.” Such clauses are used in unsecured trans-
actions as well as in those where the creditor takes a
security interest in goods in the debtor’s possession.
At common law, acceleration clauses were grouped
according to the instances which gave rise to the
creditor’s right to accelerate. In its most typical form,
the clause permitted the creditor to accelerate when the
debtor defaulted, and the contract would enumerate
those instances which constituted default 7 — usually non-
payment of principal or interest. 8 The other form of
acceleration clause allowed the creditor to accelerate at
will when he deemed himself Insecure. 9 Under common
law the creditor had the burden of justifying the
acceleration and proving his “good faith.” 10 Courts
would not enforce acceleration clauses if the creditor
had accelerated in “bad faith” or if the clause provided
that upon acceleration not only the principal but the full
amount of the interest for the full term of the contract
also came due. 1 1 Once the creditor had established his
right to accelerate, he was usually authorized to collect
, the entire principal plus legal interest. But upon default
in conditional sales contracts where the creditor also had
a security interest in goods in the possession of the
debtor, the creditor had to elect his remedy to deter-
mine the method of recovery. 1 2 He could either exercise
his right of possession and take back the goods (on the
theory that title in the goods was reserved to him by the
conditional sales contract) or he could forego reposses-
sion and sue the debtor for the amount owed. Under the
first option the creditor would be relying solely on the
value of the collateral, and if it were not sufficient to
discharge the debt in full, he would lose the amount of
the deficiency. Under the second option, the creditor
would be relying oil all of the nonexempt assets of the
debtor; if the debtor were insolvent, the creditor would
collect nothing.
The Code specifically allows acceleration triggered by
the creditor’s insecurity as well as by default. Upon
default a secured party has the power to repossess
collateral without judicial intervention, provided the
parties have enumerated the conditions of default in the
contract.
Under section 1-208 of the Code, a creditor may
accelerate “at will” or “when he deems himself inse-
cure,” if he is in “good faith” and believes the prospect
of his receiving payment has been impaired. The test of
“good faith” is totally subjective and allows the
creditor’s judgment alone to determine whether pay-
ment is likely to be forthcoming or the security is
endangered. A further complication under the Code is
that if a creditor accelerates under a “deem-insecure”
clause, the burden of proving the creditor did not act in
“good faith”— that he actually did not believe his
security was about to be impaired— falls on the debtor. If
the creditor retakes the collateral, allegedly following a
debtor’s default, the burden of proving that the default
did not occur also falls on the debtor.
The validity of acceleration after default is sound and'
essential to effective remedial action by the creditor
24
since it would be unduly onerous, inequitable, and
expensive to require the creditor to sue for each
instalment of the contract as it became due after the
initial default. However, it is equally onerous and
inequitable to place on the debtor the burden of proving
a creditor’s “bad faith” in invoicing acceleration solely
on the basis of insecurity.
Acceleration of the maturity of all or any part of the
amount owing in a consumer credit transaction should
not be permitted unless a default as specified in the
contract or agreement has occurred.
A creditor should not be able to accelerate the
maturity of a consumer credit obligation, commence any
action, or demand or take possession of any collateral,
unless the debtor is in default, and then only after he has
given 14 days prior written notice to the debtor of the
alleged default, the amount of the delinquency (inclu-
ding late charges), the debtor's right to cure the default,
and any performance in addition to payment required to
cure the default.
Under such circumstances, for 14 days after notice
has been mailed, a debtor should have the right to cure a
default arising under a consumer credit obligation by:
1. tendering the amount of all unpaid ■ instalments
due at the time of tender, without acceleration,
plus any unpaid delinquency charges; and by
2. tendering any performance necessary to cure a
default other than nonpayment of accounts due.
However, a debtor should be able to cure no more
than three defaults during the term of the contract.
After curing default the debtor should be restored to
all his rights under the consumer credit obligation as
though no default had occurred.
Acceleration should be permitted only upon the
actual default of the debtor. A consumer-debtor should
not be subject to the acceleration of the maturity of his
obligation solely because the creditor believes the
prospect of payment of the debt has been impaired.
Default should not be defined by statute, but should be
left to the determination of the parties according to the
terms of the contract. But default should not result from
technical violations of minor contract terms or from
violations of terms unrelated to ensuring payment of the
debt or maintaining the reasonable value of the security;
it should result only front the breach of major contract
provisions, such as failure to make timely payments of
interest or principal, unauthorized disposition of col-
lateral, or failure to keep the collateral insured. 1 3
The Commission believes a debtor should be given
written notice of an alleged default so that he has
opportunity to challenge or at least question the
creditor’s determination of default. If, indeed, a default
has occurred, recommendation of a 14-day cure period
starting with the mailing of the notice of alleged default
is merely the adoption of current industry practice. The
Survey disclosed that, before declaring an account
delinquent (with all the legal consequences attendant to
such determination), banks allowed average grace
periods of 12.2 days and finance companies 16.5 days.
The average grace periods were derived from all types of
credit extended by those institutions-personai loans,
other consumer goods, bank credit cards, and auto-
mobile loans.
The right to initiate suit and repossess collateral, if
any, is important in the event of default. Perhaps
nowhere is this right more important than in the
automobile credit market where the value of the
collateral is so important. The Commission is reluctant
to interfere unnecessarily with the workings of that or
any other credit market. But since grace periods allowed
in the auto credit market were included in the computa-
tion of the overall average grace period, the Commission
believes it can justifiably and safely recommend a 14-day
cure of default period for all credit markets without
unduly jeopardizing the creditor’s collateral and oppor-
tunity to recover or unduly diminishing the availability
of credit to the consumer.
Attorneys’ Fees
In many states, creditors are able to include in
consumer credit notes and contracts a clause providing
for payment by the debtor of attorneys’ fees if the
debtor defaults on the contract. This is usually expressed
as a percentage of the amount in default irrespective of
the actual amount of attorneys’ fees incurred by the
creditor. Other states, however, prohibit such con-
tractual provisions. The prohibition is most common in
small loan laws. Section 2.413 of the Uniform Consumer
Credit Code (UCCC) provides alternatives, -one author-
izing, one prohibiting attorneys’ fees.
Consumer credit contracts or agreements should be
able to provide for payment of reasonable attorneys’
fees by the debtor in the event of default if such fees
result from referral to an attorney who is not a salaried
employee of the creditor; in no event should such fees
exceed 15 percent of the outstanding balance. However,
the agreement should further stipulate that in the event
suit is initiated by the creditor and the court finds in
favor of the consumer, the creditor should be liable for
payment of the debtor’s attorney’s fees as determined
by the court, measured by the amount of time reason-
ably expended by the consumer’s attorney and not by
the amount of the recovery.
The Survey showed that many creditors believed
attorneys’ fees were useful to collection activities and
that they often relied on that provision. But, in view of
the Survey finding that major reasons for default stem
from situations beyond the debtor’s control, the Com-
mission finds it in the best interest of all to limit
25
recovery to 15 percent of the outstanding balance owed
at default.
The Commission recommends allowing attorneys’
fees provisions in consumer credit notes and contracts
because such fees should be borne directly, but to a
reasonable extent, by the debtor. Costs of collecting
from defaulting debtors should not be borne indirectly
by all the creditor’s customers in higher rates of charge
to cover higher overhead.
Confessions of Judgment-Cognovit Notes
Confessions of judgment refers to a ^judgment taken
by warrant of attorney included in the instrument
creating the obligation and consenting to judgment
before the commencement of suit.” 14 In effect, the
debtor allows an attorney chosen by the creditor to
appear in a court of proper jurisdiction and enter
judgment at any time against the debtor without
notifying or serving process on the obligor-debtor and
usually prior to any default. When confession is allowed
at any time after execution of the contract, the creditor
is immediately permitted to acquire a judgment lien on
any property of the debtor, real or personal.
At common law, judgment by confession was per-
mitted in a pending suit and still seems to be permitted
and regulated. In such cases, unlike the confession note,
the suit has already been commenced, and the defendant
has already received service of process before execution
of the confession.
Statutory prohibition or restriction of the cognovit
note probably stemmed from a desire by most states to
preserve for the debtor his day in court. Entry of
judgment without the debtor’s knowledge gives the
creditor a powerful weapon and enables him to coerce
payment by the debtor who might otherwise have
reasonable grounds for withholding payment.
Only seven states permit confession of judgment by
warrant of attorney prior to commencement of suit. Of
these, only in Illinois, Ohio, and Pennsylvania has the
use of confessions been widespread. In 1961 a
prominent legal scholar declared that a nonnotice type
cognovit judgment violated the 14th Amendment. 15
Professor Dan Hopson argued that the consent to have
judgment entered was not consent but part of a contract
of adhesion. 16 He said the signer of a cognovit note did
not, in fact, consent to such a provision since he had no
effective choice.
In 1970 in the case of Swarb v. Lennox , a Federal
district court banned the Pennsylvania practice of taking
judgments by confession and thus obtaining a security
interest in the debtor’s property before the debtor had
an opportunity to be heard. 1 7 The court, although
recognizing that the right to a hearing might be waived,
presumed that no intelligent waiver could be made
regarding consumer credit transactions when the con-
sumer earned less than $10,000.
The Supreme Court recently affirmed in full the
decision in Swarb , including its exclusive applicability to
those earning less than $10,000. 18 While suggesting that
the Pennsylvania cognovit judgment procedure was not
unconstitutional on its face, the Court in another
decision intimated that such clauses, if part of “con-
tracts of adhesion” or resulting from “bargaining power
disparity,” might be held unconstitutional. 1 9 The
validity of cognovit notes in consumer credit transac-
tions remains uncertain and resolution of the question
appears to depend solely on the adhesiveness of con-
sumer credit transactions.
No consumer credit note or contract should be per-
mitted to contain a provision whereby the debtor
authorizes any person by warrant of attorney or other-
wise, to confess judgment on a claim arising out of the
consumer credit transaction without adequate prior
notice to the debtor and without an opportunity for the
debtor to enter a defense.
Since most states have either prohibited or severely
restricted authorizations to confess judgment, the Sur-
vey showed little need for or use of confessions of
judgment as a collection device. Further, the Com-
mission’s cross-state econometric model disclosed that
prohibition or restriction of confessions of judgment had
no significant effect on the rate of charge for consumer
credit or on its availability.
The Commission believes that consumer credit trans-
action contracts are contracts of adhesion resulting from
disparity in bargaining power between debtor and
creditor. The adhesive nature of a consumer credit
contract is a byproduct of standard forms. Yet non-
standard contracts would probably be economically
infeasible to both consumer and creditor. Since standard
forms appear to be the only viable means to conduct
consumer credit transactions in a system geared to
economies of mass production and merchandizing the
forms should represent the interests of both creditor and
debtor. To accomplish this, the Commission recom-
mends that the Bureau of Consumer Credit (Chapter 4)
be empowered to develop and recommend standards for
consumer credit contracts. In setting minimum require-
ments for such contracts, the public interest should be
the paramount concern. Such a practice prevails in the
insurance industry where insurance commissioners estab-
lish uniform policy provisions.
Cross-Collateral
Cross-collateralization is peculiar to credit sales. It
occurs when a creditor takes a security interest not only
26
in the item of the credit sale but also in other goods or
property of the purchaser. For example, if a consumer
buys a television set and the creditor retains a security
interest in the set and also takes a security interest in
other appliances of the consumer, the creditor has
cross-collateral.
Cross-collateralization may also occur in “add-on”
sales. In this type of sale, a creditor “secures” a new sale
by adding the purchase to an existing secured instalment
sales agreement and not relinquishing security interest in
previously purchased goods as each item is paid for.
Such cross-collateralization has been discouraged by
section 128(d) 20 of TIL which materially complicates
making disclosures in such transactions. But to be
absolutely certain of preventing this, the instalment
agreement should stipulate that all payments must be
applied to items acquired earliest and that the creditor
must not retain security interest in property for which
he has received payments totaling the sale price includ-
ing finance charges.
In a consumer credit sale, the creditor should not be
allowed to take a security interest in goods or property
of the debtor other than the goods or property which
are the subject of the sale. In the case of " add-on ” sales,
where the agreement provides for the amount financed
and finance charges resulting from additional sales to be
added to an existing outstanding balance, the creditor
should be able to retain his security interest in goods
previously sold to the debtor until he has received
payment equal to the sales price of the goods ( including
finance charges). For items purchased on different dates,
the first purchased should be deemed the first paid for
and for items purchased on the same date, the lowest
priced items should be deemed the first paid for.
The Survey disclosed no significant need for or use of
the cross-collateralization just described.
The Commission believes a seller-creditor should be
permitted to take a security interest only in goods which
form the basis of the credit transaction, If, as part of the
sale of new goods, the seller consolidates or refinances a
debt or debts in which a prior security interest existed
the seller should be able to retain a security interest in
such prior goods only if the payments received apply to
extinguish debts first incurred and security interests first
given. Cross-collateralization agreements in which the
seller applies payments on a pro-rata basis to all secured
items and retains an interest in all goods until the entire
debt is paid is an unconscionable practice.
Household Goods
A creditor should not be allowed to take other than a
purchase money security interest in household goods.
A creditor should be able to take a security interest in
goods which form the basis of the transaction, but
security interests in household goods should not be
allowed in any loan or consolidation transaction if the
goods were not acquired by the use of that credit. In
the event of default, such security interest in household
goods and the accompanying right to repossess or
threat to repossess such goods have far too disruptive an
impact on the family life of the debtor to be in the
public interest.
Security Interest— Repossession— Deficiency Judgment
In extending consumer credit, the creditor' is chiefly
concerned that lepl remedies provide inexpensive and
effective means for investment recovery if the consumer
fails to fulfill agreement terms. Perhaps no contract
provision gives the creditor more effective protection
than security interest and its companion remedy, the
right to repossess upon “default.” Under the Code, a
security interest is defined as “an interest in personal
property . . . which secures payment or performance of
an obligation.” If the debtor defaults, 21 the Code
provides that “unless otherwise agreed, a secured party
has . , . the right to take possession of the
collateral .... without judicial process if this can be
done without breach of the peace. . . .” In addition to
authorizing such “self-help” repossession following
debtor default, the Code provides that goods may be
taken by “action” such as replevin if “self-help” cannot
be accomplished without a breach of the peace.
Giving a creditor the right to take a security interest
in goods sold under a credit sale or acquired from
proceeds of a loan is certainly not a new practice. The
law has historically provided many devices to enable the
creditor to diminish risk of loss when financing the sale
of both consumer and commercial goods. To protect
creditors who provide funds or goods and services and
rely solely on the security of personal property, devices
such as pledges, chattel mortgages, and conditional sales
contracts 22 have “sprung up in a wild profusion.” 23
These short-term security devices have enabled lenders
to provide working capital for small- and medium-size
businesses and to assist in distribution of durable goods
to consumers.
The Code provision authorizing the secured party to
take possession of collateral following a default without
the aid of judicial process, like the security interest, is
not a novel collection tool. 24 Apparently use of
nonjudicial repossession by a conditional seller was
recognized under English common law. Rationale for its
use-fear that a debtor will abscond with, destroy, or
lose the property before relief can be obtained from the
courts— has remained constant. William Blackstone, the
noted commentator on English common law, gave the
27
following justification for proceeding without judicial
process:
“The reason . . > is obvious, since it may frequently
happen that the owner may have this only oppor-
tunity of doing himself justice: his goods may be
afterwards conveyed away or destroyed ... if he had
no speedier remedy than the ordinary process of
law.” 25
As early as 1869, a court in the United States
permitted a conditional seller peaceably to retake a
sewing machine without judicial process via the “self-
help” route. The court said it would “permit a party to
resort to every possible means for the recaption of his
property short of a breach of the peace.” 26 Courts
recognizing nonjudicial repossession as a valid collection
mechanism brought about statutory sanction first in
1919 when the National Conference of Commissioners
on Uniform State Laws promulgated the Uniform
Conditional Sales Act (U.C.S.A.). Section 1 of the Act
specifically authorized peaceable nonjudicial reposses-
sion upon the debtor’s default.
Self-help repossession has come under severe criticism
in recent years as being a particularly abusive collection
practice in the area of consumer credit. 27 Professor
Grant Gilmore, one of the drafters of Article 9 of the
Code, observed:
“In the financing of business debtors repossession
causes little trouble or dispute. In the underworld of
consumer finance, however, repossession is a knock-
down, drag-out battle waged on both sides with
cunning and guile and a complete disregard for the
rules of fair play.” 2 8
The part of the security interest— repossession process
which evokes greatest emotion and criticism is the
deficiency judgment. The Code permits the creditor to
dispose of the collateral by “public” or “private” sale so
long as the sale is, in fact, “commercially reasonable.”
After sale of collateral the proceeds, before being
applied to reduce the consumer’s debt, may be used to
defray “the reasonable expenses for retaking, holding,
preparing for sale, selling and the like and, to the extent
provided for in the agreement and not prohibited by
law, the reasonable attorneys’ fees and legal expenses
incurred by the secured party.” The remainder is
credited to the debt. If the residual applied to the debt is
not sufficient to pay it in full (usually it is not), the
debtor still owes the secured party the unpaid balance
even though he has lost possession and ownership of the
goods. For example, if a debt of $2,000 secured by an
automobile is defaulted and the car repossessed and sold
for $1,800 at public sale, the creditor may apply the
proceeds first to expenses incurred in the repossession
and sale (say $300) and the balance ($1,500) to the
debt. The debtor would still owe the creditor $500
''s-spite loss of the car.
What might be “commercially reasonable” for a .
commercial creditor and a commercial debtor might not
be “reasonable” for a consumer debtor. The latitude the
Code allows the secured party in conducting foreclosure
sales seems excessive in consumer transactions. The Code
shields the secured party with the seal of commercial
reasonableness if he sells the collateral “in the usual
manner in any recognized market” or at the price
“current ... at the time” in any recognized market, or
finally, “if he has otherwise sold in conformity
with .... practices among dealers in the type of prop-
erty sold.”
Guidelines of the Code clearly sanction wholesale
auction sales (the usual manner of disposing of used
consumer durables such as autos) since a foreclosure sale
is not considered lacking in commercial reasonableness
merely “because a better price could have been obtained
at a sale at a different time or in a different method
from that selected by the secured party.”
Use of the Code approved wholesale auction sale
virtually guarantees that if the consumer debtor defaults
he will be subject to a deficiency. The collateral
purchased in the retail market for a retail price is sold
after repossession in the wholesale market for a whole-
sale price. Since most defaults and repossessions usually
occur shortly after purchase of the collateral (before
much of the debt has been repaid but after the goods
have changed from “new” to “used”), the difference in
prices between the wholesale and retail markets Is
particularly wide.
It seems illogical to contend, however, that creditors
gear their operations to repossess and then get the
“benefit” of the deficiency judgment. A Commission
study indicates that except for a few “sharp” dealers this
is not the case. 29
Despite Code sanctions, the very nature of the
creditor-dominated consumer contract has caused several
courts and state legislatures 30 recently to look with
disfavor on the security interest, self-help repossession-
replevin, deficiency judgment package. Scrutiny of all
remedies which could unilaterally be invoked by a
private party to cause state power to deprive a person of
his property began after the Supreme Count decision in
Sniadach v. Family Finance Corporation , 31 The Court
held that the Wisconsin statute authorizing prejudgment
garnishment of a resident debtor’s wages without any
opportunity for prior hearing on the merits of the
creditor’s claim was a deprivation of the debtor’s
property without due process of law and a violation of
the 14th Amendment.
In June 1 972 the Supreme Court in Fuentes et al v.
Shevin held that the Florida and Pennsylvania replevin
statutes were unconstitutional because they provided for
issuance of prejudgment writs of replevin “ordering state
agents to seize a person’s possessions simply upon the ex
28
parte application of any person who claims a right to
them and posts a bond. 32 The Court pointed out that
neither statute provided for notice to be given the
possessor of the property or afforded the possessor
opportunity to challenge the seizure or any kind of prior
hearing. It also noted that prejudgment replevin statutes
were descendants of common law actions which per-
mitted prejudgment seizure by state power. But the
Court emphasized that the common law required “some
kind of notice and opportunity to be heard to the party
then in possession of the property and a state official
made at least a summary determination of the relative
rights of the disputing parties before stepping into the
dispute and taking goods from one of them.” 33
Although the Court’s opinion in Fuentes seems
directed only at instances in prejudgment seizure cases
when the state acts to deprive a person of property
without prior notice and opportunity to be heard, many
constitutional scholars feel that after Fuentes the demise
of self-help repossession is inevitable . There is some basis
for this view. In McCormack v. First National Bank of
Miami 34 the Federal district court tested the constitu-
tionality of self-help repossession provisions of the Code
against the due process criteria of Sniadach and found
the provisions constitutionally sound. It upheld the
constitutionality of self-help repossession when such
right was provided for by contract and refused to
distinguish self-help from a contractual authorization of
replevin. The irony of this result is that the court felt
compelled to follow the decision of the Federal district
court in Fuentes v. Faircloth , 35 the very decision which
the Supreme Court overruled and in winch prejudgment
replevin, even though contractually authorized, was held
unconstitutional. In other words, if the Supreme Court’s
decision in Fuentes had been decided prior to the
McCormack case, the court in McCormack would have
found self-help repossession unconstitutional. 36
More recently, in the case of Adams v. Fgley, the
Federal District Court for the Southern District of
California found self-help repossession, as allowed by the
Code, to violate the due process clause of the 1 4th
Amendment.
In spite of arguments, that self-help repossession was
stipulated in the security agreements and therefore a
matter of private contract, the court found that Code
Sections 9-503 and 9-504 authorizing self-help and
deficiencies set forth a state policy
“and the security agreements upon which the instant
actions rest, whose terms are authorized by the
statute and which incorporate its provisions, are
merely an embodiment of that policy.” 37
The court emphasized that it was “therefore apparent
that the repossessions were made under color of state
law” and that the Code sections authorizing such
activities were “constitutionally defective and void.” 38
Having decided that self-help repossession was “state
action” sufficient to entitle parties who would be
deprived of property to due process protections of
notice and opportunity to be heard, the court con-
sidered whether a consumer in a credit transaction could
waive his constitutional rights. It determined that “while
a signed contract may represent an effective waiver
where the contracting parties are of equal bargaining
power, it clearly is not so in all cases, particularly those
involving so-called ‘adhesion contracts’, in which the
terms are specified by the seller or lender.” 39 Citing the
case of Laprease v. Raymours Furniture Co, in which the
prejudgment replevin statute of New York was found
unconstitutional, the court in Adams v. Egley intimated
that it would not be able to find an effective waiver of
constitutional rights where standard-form contracts were
involved. 40 The attitude toward “adhesion” in Adams v.
Egley may well cause the greatest problems for creditOis.
The Supreme Court in Fuentes also dealt with the
matter of adhesion contracts, pointing out that in the
Fuentes contracts “there was no bargaining over con-
tractual terms between the parties, who, in any event,
were far from equal in bargaining power.” 4 ' The Court
emphasized that the “purported waiver provision (in the
security agreement) was a printed part of a form sales
contract and a necessary condition of the sale.” 42 The
intimation seems clear: it is unlikely that a waiver of the
right to notice and opportunity to be heard can be
“voluntarily, intelligently and knowingly” 43 made in a
consumer credit contract.
A seller-creditor should have the tight to repossess
goods in which a security interest exists upon default of
contract obligations by the purchaser-debtor. At the
time the creditor sends notice of the cure period ( 14
days), and prior to actual repossession (whether by
replevin with the aid of state officers or by self-help), he
may simultaneously send notice of the underlying claim
against the debtor, and the debtor should be afforded an
opportunity to be heard in court on the merits of such
claim Such time period for an opportunity to be heard
may run concurrently with the cure period.
Where default occurs on a secured credit sale in which
the original sales price was $1,765 or less, or on a loan in
which the original amount financed was $1,765 or less
and the creditor took a security interest in goods
purchased with the proceeds of such loan or in other
collateral to secure the loan, the creditor should be
required to elect remedies; either to repossess collateral
in full satisfaction of the debt without the right to seek a
deficiency judgment or to sue for a personal judgment
on the obligation without recourse to the collateral, but
not both.
The Survey disclosed that creditors thought the single
most important remedy or contract provision in a
secured consumer credit transaction was the right to
29
take a security interest in the goods (use the goods as
collateral for the transaction) and the concomitant right
to repossess if the debtor defaulted.
At the time of the Survey virtually all states
permitted creditors to take a security interest in goods
and to repossess for debtor default, so the Commission
could not measure what impact restriction or abolition
of these companion collection devices might have on
availability of consumer credit and rates charged for it.
The Commission is unable to predict with any certainty
probable effects of limitations, but the degree of
creditor support for these collection devices indicates
that any restriction, much less abolition, of them would
probably have significant impact on rates charged for
consumer credit and its availability. There is little doubt
that the rate of charge would be substantially increased
and availability severely curtailed if the right to a
security interest and to repossess were restricted.
With full understanding of its probable impact, the
Commission, nevertheless, recommends that prior to
repossession— whether with or without judicial process—
the debtor must be given notice of the claim against him
and the opportunity to be heard on the merits of the
underlying claim.
Leaving legal niceties for the courts, this recom-
mendation is based on the concept that an individual has
the right to continued “use and possession of property
(free) from arbitrary encroachment.” 44 If the evil to be
eliminated is that of depriving a person of his property
rights without procedural due process of law, the right
to notice and an opportunity to be heard must apply
across the board, irrespective of the type of reposses-
sion-“self-help,” replevin, or whatever.
The type of notice to be given the debtor and the
nature of the hearing are of critical importance. The
Commission believes that the type of summons recently
adopted under the Wisconsin Consumer Act would
provide the debtor with adequate notice of the claim
pending against him and notice of his opportunity to be
heard. The notiee reads:
“The Plaintiff named above has commenced an action to
recover possession of the following property :
[Description of Collateral]
This claim arises under a consumer credit transaction
under which yon are alleged to be in default, as described in
the attached complaint.
If you are not in default or have an objection to the
Plaintiffs taking the property listed above, you may arrange
for a hearing on these issues by appearing in the County
Court of County, in the Courthouse in
the City of Judge or
any other Judge of said Court to whom the action may be
assigned, on day of A.D. 19
at ______ o’clock in the noon. If you do not
appear at that time, judgment will be rendered against you
for delivery of such property to the plaintiff.”
The nature of the hearing, however, presents a more
difficult problem. Offering the debtor an opportunity to
be heard does not guarantee the debtor will avail himself
of the opportunity. The Survey showed that in approxi-
mately 65 percent of all court cases the consumer failed
to appear and judgment was entered by default for the
creditor-plaintiff. There is no reason to believe that a
greater percentage of debtors would appear at hearings
prior to repossessions.
A ‘‘probable cause” type hearing, where the secured
party and debtor have an opportunity to appear to
present their case and to file affidarits, would probably
satisfy the opportunity-to-be-heard requirement of the
14th Amendment. Although hearings of this type would
probably be unduly burdensome to the existing court
system, the Commission insists that an opportunity . for
hearing should be granted.
Although the functioning and structure of the exist-
ing court system is beyond Commission purview, this
panel notes that reorganization of the courts is desper-
ately needed. In many jurisdictions, the courts are now
unable to accommodate existing caseloads. They will be
completely incapable of handling efficiently the large
number of cases generated by proliferating consumer
pro tec lion laws, to say nothing of the hearings herein
recommended. The Commission strongly endorses a
reorganization of the court system and supports any
actions necessary to accomplish that end.
The recommendation to prohibit deficiency judg-
ments for default on a secured credit sale in which the
original price was $1,765 or less or on a loan in which
the original amount financed was $ 1 ,765 or less is made
despite the probability of increased rates of charge on
sjich transactions and reduced availability. But the
Commission believes implementation of that recom-
mendation would afford consumers protection in areas
particularly susceptible of abuse by exempting most
household goods purchases from deficiency judgments
and putting an end. to deficiency judgment abuses found
in some used car markets.
The Commission position on this recommendation
and the $1,765 figure designated are derived from the
Commission hearings on collection practices and findings
of a Commission Study on Repossession of Cars in the
District of Columbia. Both highlighted deficiency judg-
ment mechanism problems peculiar to the used car
market. To isolate this market, the Commission deter-
mined the point in 1972 at which new and used car
markets were no longer in competition. Aware that the
average automobile loan approaches 100 percent of
dealer cost, the Commission ascertained dealer cost of
the lowest priced passenger cars made by each U.S.
30
automobile manufacturer and computed an average of
$1,765 . 4s Automobile credit higher than that figure
would more likely be extended to buy a new rather than
a used car. So it was at the figure of $1 ,765 or less that
the Commission determined the 1972 new car market
was not in substantial competition with the used car
market. The figure should be recomputed annually using
average prices of the least expensive American -made
passenger cars.
Since most major household goods such as stoves,
refrigerators, washers, dryers, and furniture do not
separately cost more than $1,765, the prohibition
against deficiencies provides the consumer some protec-
tion in major household purchases. The Commission
believes that if the debtor defaults after purchasing
major household goods, the creditor should have the
option of repossessing or suing on the debt, but not .
both. To allow otherwise would cause too great a
personal hardship.
Wage Assignment
Wage assignment is a transfer by a debtor to a
creditor of the debtor’s right to collect all or a given part
of his wages, earned and unearned. Traditionally, the
wage assignment was irrevocable and was taken by the
creditor as either payment or security for a debt. Its
function, like self-help repossession, was to provide the
creditor with a speedy method of collection without a
hearing on the merits of tire underlying claim.
Many states have restricted the right of the creditor
to obtain wage assignments. The restrictions cover a full
range. In some states, wage assignments are completely
prohibited; in others they are limited to a given
percentage of the debtor’s earnings. Some states require
that the assignment be accepted by the debtor’s em-
ployer.
The validity of wage assignments is in doubt because
of recent decisions in Sniadach and Overmeyer. While
wage assignments are distinguishable from prejudgment
garnishment in that the former are contractual, they are
essentially contracts of adhesion. The policy enunciated
in Sniadach regarding protection of wages and the
statements in Overmeyer holding that if the contract
were adhesive “other results might ensue” suggest that
the future of wage assignments as collection devices is
clouded.
In consumer credit transactions involving an amount
financed exceeding $300, a creditor should not be
permitted to take from the debtor any assignment, order
for payment, or deduction of any salary, wages, commis-
sions, or other compensation for services or any part
thereof earned or to be earned. In consumer credit
transactions involving an amount financed of $300 or
less, where the creditor does not take a security interest
in any property of the debtor, the creditor should be
permitted to take a wage assignment but in an amount
not to exceed the lesser of 25 percent of the debtor’s
disposable earnings for any workweek or the amount by
which his disposable earnings for the workweek exceeds
40 times the Federal minimum hourly wage prescribed
by section 6(a) (1) of the Fair Labor Standards Act of
1 938 in effect at the time.
Wage assignments generally represent a potentially
disruptive force to the wage earner, the family, and their
pattern of living. The irrevocable wage assignment
permits the creditor to reach the debtor’s past and, in
many cases, future earnings without a determination by
the courts on the merits of the underlying claim. The
Commission makes this recommendation despite find-
ings from the cross-state econometric model that restric-
tions or prohibitions on the use of wage assignments
would reduce the number and amount of credit union
personal loans.
The Commission also recognizes that small unsecured
loans which often serve a useful purpose would not be
made available unless the creditor had an effective and
inexpensive method of collecting in the event of default.
For many low income wage earners, the only pledg-
able, tangible asset is a paycheck. To deny the right to
obtain credit based on that asset is to fail to recognize
the individual’s earning capacity and to withhold oppor-
tunity afforded more affluent members of society.
The Survey indicated that sales and consumer finance
companies, as well as some small banks, relied to a
significant extent on wage assignments to collect on
defaulted obligations. The cross-state econometric
analysis of the finance company sector of the personal
loan market indicated that where wage assignments were
prohibited or substantially restricted the number but not
the dollar amount of loans made per family was reduced
significantly. This suggests that restriction or prohibition
of wage assignments has greatest impact on loans of
$300 or less because significant reductions in the
number of loans of this size would not necessarily have
much impact on the total dollar amounts extended.
The unwillingness of lenders to make loans of this
size without an effective and inexpensive method of
collecting in the event of default is understandable. The
small size loan is the most costly to make in relation to
the amount lent, 46 and unless creditors can collect
without incurring additional expenses, such as attorneys’
fees and court costs, they probably would not make
such loans. The wage assignment device provides an
inexpensive method of collection.
In view of its general opposition to wage assignments,
the Commission believes they should be allowed only
when the creditor extends credit on an unsecured basis,
31
relying solely on the debtor’s earning capacity. But, it
also recommends that where a wage assignment is
allowed and becomes operative due to default, if it
should cause the debtor hardship because of an unex-
pected emergency, such as illness of the debtor or the
family, the debtor should have the right to ask an
appropriate court to stay the operation of the assign-
ment until such time as it can be reinstated without
causing undue hardship.
Waiver of Defense Clauses are discussed in the Holder
in Due Course section.
Creditors’ Remedies
Body Attachment
To the enlightened society of the 20th century, the
thought of a debtor being imprisoned for failing to pay
his debts seems preposterous and barbaric. Nevertheless,
In June 1970 the Commission was told of “debtor’s
prisons” still operating in the State of Maine. 4 7
Several articles trace the development of “Execution
Against the Body of the Judgment Debtor” from early
Roman law to the mid-20th century. 48
Most states have substantially restricted imprison-
ment for debt, either by constitutional prohibition or
statutory restraints. In some states the prohibition is
absolute, and others permit it only in specific instances,
such as when a debtor is found to have committed
willful tort or to have absconded with intent to defraud
creditors. Nevertheless, in several states debtors are still
imprisoned for failure to pay their debts but the basis
for incarceration is contempt of court for failing to obey
the court’s order to pay the debt. 49
No creditor should be permitted to cause or permit a
warrant to issue against the person of the debtor with
respect to a claim arising from a consumer credit
transaction. In addition, no court should be able to hold
a debtor in contempt for failure to pay a debt arising
from a consumer credit transaction until the debtor has
had an actual hearing to determine his ability to pay the
debt.
As a matter of public policy, if imprisonment for
debt still exists in any form, the Commission recom-
mends its abolition. However, if after final judgment,
and after notice and actual hearing and any other
necessary procedural safeguards, a court has reasonably
determined that the debtor has refused to pay a
court -ordered sum when he has capacity to do so, the
court should be able to initiate contempt proceedings.
Garnishment
Garnishment is a “statutory proceeding whereby [a]
person’s property, money or credit in possession or
under control of, or owing by, another are applied to the
payment of the former’s debt to [a] third per-
son . . . . ” s 0 As it applies to wages and salaries, the
process of garnishment requires an employer to withhold
part of an employee’s compensation upon order of the
court and pay it directly to, or for the account of, the
employee’s creditor.
In spite of the description of garnishment as a
“statutory proceeding,” garnishment proceedings “are
truly blue-blooded legal institutions that can claim a
family tree reaching back into the Middle Ages.” 51
Garnishment is a descendant of the procedure of
“foreign attachment,” whereby a plaintiff who brought
suit against a nonresident defendant could attach the
defendant’s goods found in the hands of a third person
or stop payment of debts owed by the third party to the
nonresident defendant. If the nonresident failed to
appear at the trial and had a judgment entered against
him, the plaintiff could seek satisfaction out of the
nonresident’s seized assets 5 2
Attachment procedures made an early appearance in
the Colonies, 53 and in 1683 s4 the province of Maryland
passed the oldest known garnishment act in the United
States. It regulated attachment proceedings against
absentee defendants when third persons had in their
possession “goods, chattels, or credits” belonging to the
absentee defendants. The third parties were labeled
“garnishees” and given specific liability regarding the
garnished items.
Late in the 17th century and throughout the 18th
century attachment statutes were made applicable to
domestic defendants. The creditor could “reach and
apply” the assets— “chattels, goods or credits”-of
domestic debtors about to flee the jurisdiction. When
attachment was so used, it served a security function—
the function garnishment of wages has in consumer
credit transactions today.
The 19 th century saw considerable legislative and
judicial expansion of the nature of property which could
be reached in satisfaction of debt. 5 5 “Wage garnishment
followed as a logical extension of this trend. Since wage
garnishment developed after the abolition of debtor’s
prisons, it did not seem unreasonable and was in the
spirit of the nineteenth century principles of freedom of
contract and survival of the fittest. . . . [PJ olicy factors
involved in allowing creditors to force a wage cut on
blue collar employees were never seriously considered in
the formative years of the remedy, a period when the
primitive industrial state did not require massive con-
sumer credit. Subsequently, state legislatures, acting
alternatively under the pressures of both organized
labor, and the business community, attempted to
regulate the remedy by exemptions, inclusions and
exclusions producing a quagmire of difficult and con-
fusing rules.” 56
32
During the 20th century state legislatures were active
in enacting restrictions on wage garnishment laws devel-
oped during previous years. Exemptions and exceptions
ranged from complete prohibition to limitations based
on various percentages of salaries in excess of a given
amount, to limitations based on the character of the
wages and status of the person whose wages were being
garnished.
In today’s consumer credit market, garnishment of
some percentage of a debtor’s wages seems justifiable
and necessary. In most consumer credit transactions, the
only asset of the consumer on which the creditor relies
for his security is the consumer’s earning power. It is not
surprising that the creditor should expect to be able,
and, some might argue, be entitled, to reach some
portion of that asset in the event of the debtor’s default.
Both Congress and the Supreme Court appear to agree
that the creditor is entitled to garnish a debtor’s wages.
Congress has prescribed the maximum amount of the
garnishment and the Court has proscribed the method of
garnishment.
The restriction on garnishment in the Consumer
Credit Protection Act (CCPA) became effective on
July 1, 1970. It provides that
“{Tjhe maximum part of the aggregate disposable
earnings of an individual for any workweek which is
subjected to garnishment may not exceed
(1) 25 per centum of his disposable earnings for
that week, or
(2) the amount by which his disposable earnings
for that week exceed thirty times the Federal
minimum hourly wage . . . whichever is less.”
Restated, the CCPA’s Title III exempts from garnish-
ment whichever is greater-75 percent or $48
(30 X 1.60, the current minimum wage)-of the debtor’s
disposable income per workweek.
Example 1.
If a debtor has a disposable income of $ 100 per week,
$75 is exempt from garnishment.
Example 2.
If a debtor has a disposable income of $55 per week
$48 is exempt from garnishment (75 percent would
be only $41 .25).
In addition to limiting the amount of wages subject to
garnishment. Title III provides that “no employer may
discharge any employee by reason of the fact that his
earnings have been subjected to garnishment for any one
indebtedness.” Title III exemptions from garnishment
are minimum exemptions because the Act specifically
provides that it does not annul, alter, or affect state laws
which prohibit garnishment or provide more limited
garnishment than does the CCPA or prohibit discharge
of an employee for garnishment.
As to garnishment methods, the Supreme Court has
held that a garnishment cannot be obtained against a
debtor residing in the state where the garnishment is
sought simply on petition of one party -“the creditor-
before judgment. The. Court in Sniadach v. Family
Finance Corporation held that the temporary with-
holding of a resident debtor’s wages under a garnishment
order without opportunity for the debtor to be heard or
to present any available defense to the creditor’s claim
was violative of procedural due process granted under
the 14th Amendment. Justice Douglas, writing for the
majority, held that such prejudgment garnishment
affords “enormous” leverage to creditors and “may as a
practical matter drive a wage -earning family to the
wall.” 57 Prejudgment garnishment of out-of-state
debtors is apparently still permitted.
Prejudgment garnishment, even of nonresident
debtors, should be abolished. After entry of judgment
against the debtor on a claim arising out of a consumer
credit transaction, the maximum disposable earnings of a
debtor subject to garnishment should not exceed the
lesser of:
1. 25 percent of his disposable earnings for the
workweek, or
2. The amount by which his disposable earnings for
the workweek exceeds 40 times the Federal
minimum hourly wage prescribed by section
6(a) (1) of the Fair Labor Standards Act of 1938,
in effect at the time the earnings are payable. (In
the event of earnings payable for a period greater
than a week, an appropriate multiple of the
Federal minimum hourly wage would be appli-
cable.)
A debtor should be afforded an opportunity to be
heard and introduce evidence that the amount of salary
authorized to be garnished would cause undue hardship
to him and/or his family. In the event undue hardship is
proved to the satisfaction of the court, the amount of
the garnishment should be reduced or the garnishment
removed . - -
No employer should be permitted to discharge or
suspend an employee solely because of any number of
garnishments or attempted garnishments by the
employee’s creditors.
The Commission believes that Title III of CCPA was a
giant step toward more effective and equitable consumer
protection. It put limits on garnishment where none-or
almost none-existed in many states, and it geared those
Emits to the minimum wage, not to an inflexible dollar
amount. It provided the debtor-employee with some
measure of job security in the event of garnishment for
33
one debt. But the Commission feels that the CCPA
protections should be further improved.
A wage earner working a full 40-hour week at the
minimum hourly rate earns, by standards recognized by
Congress, the minimum amount necessary to support a
family at a bare subsistence level. To exempt from
garnishment an amount based on a 30-hour workweek
seems unreasonable. It does not afford those employees
earning the minimum wage with adequate means to
provide basic necessities. For this reason the Commission
recommends that the exempted portion of an
employee’s salary be increased to 40 times the Federal
minimum wage .
The Commission recommends that an employee
should not be subject to discharge for garnishments or
attempted garnishments by any number of creditors
because the loss of employment causes further hardship
on the debtor and his family and virtually guarantees
inability to satisfy any obligations. Furthermore, the
Commission feels that creditors should not be able to
garnish indiscriminately the nonexempt portion of the
debtor’s disposable income. In given circumstances, such
as illness in the family and previous unemployment,
garnishment of the nonexempted portion of the debtor’s
salary may make it impossible for him to provide for
himself and his family. Under such extraordinary cir-
cumstances, the Commission believes the debtor should
have an opportunity to present the facts to a court and
let the court, if it deems proper, adjust the amount of
the garnishment.
Because garnishment is one of the most common and
effective means by which a creditor can enforce a
judgment against a defaulting debtor, it was deemed an
essential collection device by both secured and unse-
cured creditors in the Commission’s Survey, It was
considered the most essential remedy by creditors
extending unsecured credit, and in secured transactions
it was ranked second only to the right to take a security
interest. The cross-state econometric model indicated
that in states where garnishment was either prohibited or
restricted beyond limitations imposed by the CCPA, the
availability of credit was substantially curtailed, and
charges for credit were apparently increased. These
findings lead the Commission to recommend that gar-
nishment be allowed in all states subject to the restric-
tions discussed.
Holder in Due Course Doctrine-
Waiver of Defense— Closely-Connected Loans
Of all creditors’ remedies and collection devices used
in consumer credit notes and contracts, perhaps none has
received as much notoriety, commentary, and contro-
versy as the holder in due course (HIDC) doctrine. 5 8
In 1758, in the case of Miller v. Race, the King’s
Bench of England held that a Bank of England promis-
sory bearer note was “treated as money; as cash” by
businessmen dealing “in the ordinary course and trans-
action of business.” 59 The court decided that when such
a note was stolen and thereafter sold to a person who
paid fair value and had no notice of the theft (a bona
fide purchaser), that bona fide purchaser would prevail
over ail persons claiming the note, even the original
owner. The rationale for this decision was based on the
fear that the growth and soundness of commerce would
have been impeded or destroyed if a contrary decision
were reached. 60 This fear was probably well-founded
because promissory notes of the Bank of England were
not “legal tender,” 61 but were nevertheless “passed
from hand to hand, serving many of the purposes of
paper money, which did not exist in England at the
time.” 62 To allow persons other than bona fide pur-
chasers to claim ownership to the note would indeed
have had an adverse affect on commerce.
With the development of paper money, the emphasis
on affording a good faith purchaser of notes and
contracts freedom from claims to the instrument
gradually shifted to permit the good faith purchaser to
cut off defenses which the obligor may have against
paying the note.
Today, under the Code an individual can qualify as
HIDC if he takes an instrument for “value,” “in good
faith” and “without notice that it [the instrument] is
overdue or has been dishonored or of any defense
against or claim to it on the part of any person.” The
status of HIDC provides many advantages against the
individual obligated on the instrument, and these advan-
tages are brought into sharp focus where the instrument
is used in a consumer credit transaction.
In a typical consumer credit purchase of durable
goods, the purchaser signs an instalment note to the
seller agreeing to repay the unpaid portion of the
purchase price plus finance charges in accordance with a
stipulated repayment schedule. The seller, in turn,
“negotiates” the note to a financing institution (usually
a sales finance company or bank). In most of these
transactions the financing institution has the status of
HIDC and can enforce the purchaser’s obligation on the
note irrespective of any defenses which the buyer may
have against the seller regarding the underlying sale. For
example, if a purchaser signs a note as payment or
partial payment for a refrigerator, the financing institu-
tion holding the note as HIDC is entitled to receive
payment even though the refrigerator was defective, was
never delivered, or, if delivered was not as represented at
the time of the sale.
Another legal device, the waiver of defense clause,
provides financing institutions immunity from defenses
34 .
to payment which the buyer may be able to assert
against the seller. It operates in essentially the same way
as the HIDC doctrine. A waiver of defense clause is part
of an instalment sales contract (as distinguished from a
note) and, in effect, provides to the assignee of the
contract the benefits of negotiability and HIDC status
through a contractual provision.
The following is an example of a typical waiver of
defense clause:
“If the seller should assign the contract in good
faith to a third party, the buyer shall be precluded
as against such third party from attacking the
validity of the contract on grounds of fraud,
duress, mistake, want of consideration or ”
The Code specifically permits such clauses, unless
there is a “statute or decision which establishes a
different rule for buyers or lessees of consumer
goods. . .”
Recently, both courts and legislatures have begun to
reassess and scrutinize the validity and the impact of the
HIDC doctrine and waiver of defense clauses in con-
sumer credit transactions. A number of courts have
denied HIDC status to lenders in “too close connection”
with sellers of consumer goods . 63 A number of state
legislatures have prohibited use of negotiable instru-
ments, and, therefore HIDC status, in retail instalment
sales of “service .” 64 Waiver of defense clauses in
consumer sales contracts have also been held void as
against public policy by a number of courts 65 and
prohibited by several legislatures . 66
Besides absolutely prohibiting the use of negotiable
instruments and waiver of defense clauses in consumer
transactions, a number of state legislatures have limited
the prohibition to certain spheres of the consumer credit
market or have only prohibited the use of waivers and
not HIDC . 67 Others have provided a delay period before
the cut-off of defenses becomes effective . 68 The finan-
cial institution is required to give notice to the consumer
of the assignment and sale of the contract or note and
identify the seller of the goods. Thereafter the consumer
has a limited period of time to notify the financial
institution of any complaints or objections regarding the
merchandise. If the financial institution does not receive
such notice within the time period, any defenses which
the buyer may have had against the seller can be cut off
by the financial institution.
As far as the Commission can determine, the delaying
type statute affords the consumer no real protection.
The financing institution sends the notice of transfer to
the consumer as a routine matter on transfer, and it is
unlikely that the consumer would know of any defects
or defenses other than nondelivery at the time of
receipt of the notice of transfer. Most of these statutes
provide an unrealistically short period in which to assert
a defense. Finally, it is possible that if the seller of the
goods sold the paper immediately, notice of assignment
might be received by the consumer before the delivery
date.
In addition to activity at the state level, a proposed
trade rule offered at one time by the FTC but later
withdrawn would have made the use of either HIDC
status or a waiver of defense clause in a consumer
transaction an unfair and deceptive practice . 6 9
Growing discontent with cut-off devices in consumer
transactions, now apparent in legislatures, courts, and
administrative agencies, has led many dealers and fi-
nancing institutions to devise a new and effective
method for the lender to cut off any defenses the buyer
might have against the seller. The seller merely suggests
that the buyer borrow money for the purchase by direct
loan from a cash lender and directs the buyer to a
financing institution willing to make the loan. Theoret-
ically, at least, the loan is an independent transaction
with no relation to the purchase of the goods. As a
result, the obligation to repay the debt would not be
subject to defenses arising out of the purchase transac-
tion even in states limiting the HIDC doctrine and use of
waiver of defense clauses. The Commission believes
routine referral by a seller to a lender or group of lenders
should not be permitted to subvert the policy behind a
rale restricting or prohibiting use of negotiable promis-
sory notes or waiver of defense clauses. However,
drafting legislation barring routine referrals but not
inhibiting direct lending for consumer purchases by
institutions totally independent of sellers is a difficult
task . 70
Whatever the methods, it is quite apparent that
cut-off devices against defenses which a purchaser of
consumer goods may have against the seller of such
goods are in great disfavor in many courts and with
many legislators. Many noted legal scholars also agree
that cut-off devices are not necessary in consumer
transactions . 71
Notes executed in connection with consumer credit
transactions should not be “ negotiable instruments
that is, any holder of such a note should be subject to all
the claims and defenses of the maker ( the consumer-
debtor). However, the holder’s liability should not
exceed the original amount financed. Each such note
should be required to have the legend “Consumer
Note-No t Negotiable” clearly and conspicuously printed
on its face.
Holders of contracts and other evidences of debt
which are executed in connection with consumer credit
transactions other than notes should similarly be subject
to all claims and defenses of the consumer-debtor arising
out of the transaction notwithstanding any agreement to
the contraty. However, the holder’s liability should not
exceed the original amount financed.
35
A creditor in a consumer loan transaction should be
subject to all of the claims and defenses of the borrower
arising from the purchase of goods or services purchased
with the proceeds of the loan, if the borrower was
referred or otherwise directed to the lender by the
vendor of those goods or services and the lender
extended the credit pursuant to a continuing business
relationship with the vendor. In such cases, the lender’s
liability should not exceed the lesser of the amount
financed or the sales price of the goods or services
purchased with the proceeds of the loan.
Responses to the Commission’s Survey disclosed that
very few creditors engaged in purchasing consumer
credit notes and contracts thought that the HIDC
doctrine or waiver of defense clauses were among the
legal tools most essential to collection activities; but
they did indicate reliance on these collection devices to a
significant extent in legal actions to collect defaulted
obligations.
The cross-state econometric model indicates that in
those states which have prohibited both HIDC and
waiver of defense clauses there has been an observable
reduction in the availability of other consumer goods
credit in two areas: consumer finance companies pur-
chased less other consumer goods paper, and the total
amount of other consumer goods credit made available
in the retail market declined, Traditionally, finance com-
panies have served the greatest proportion of retailers
dealing with high risk credit customers, although banks,
too, serve that market. The reductions in availability of
other consumer goods credit from finance companies, in
all likelihood, would have the greatest impact on
consumers who are marginal credit risks and on those
businesses which serve or may potentially serve such
consumers.
The cross-state econometric model results also suggest
that if finance companies cannot take other consumer
goods paper free from claims and defenses to quality of
the goods and services, the reduction in credit avail-
ability in the other consumer goods retail market would
probably be greater than that of the finance company
component of the market. Finance companies could
reduce their activity in the market by quality credit
rationing— rejecting higher risk customers to reduce costs
and offset additional potential credit losses. This, in
turn, would probably force out of the market many
retailers serving marginal risk consumers unable to
obtain credit from general market retailers. Because
many of these marginal retailers are undercapitalized and
tend to be basically inefficient 7 2 they depend on
finance company purchase of paper to restock their
inventories. These same limitations would prevent other
potential small retailers from entering the market in the
absence of finance company other consumer goods
credit.
At tire time of the Survey, all states allowed either
HIDC or waiver of defense clauses or some other equally
effective cut-off device in the indirect automobile mar-
ket. For this reason comparable data were not available
to test the effect of prohibiting HIDC and waiver of
defense clauses on availability of indirect automobile
credit, However, no evidence is available to show that
the effect of such prohibitions in the auto indirect
market would have any less Impact than in the other
consumer goods market.
In recommending abolition of HIDC and waiver of
defense clauses in consumer credit transactions, the
Commission recognizes that it is placing the burden of
policing consumer transactions on the financial institu-
tions which purchase consumer paper. The Commission
believes those financial institutions are in a much better
position to control credit practices of retail suppliers of
consumer goods and services than are consumers. They
can choose the retailers and suppliers with whom they
will do business, If a financial institution is subject to
consumers’ defenses against payment, such as failure of
consideration, nondelivery, etc,, it will discontinue
purchase of paper from those merchants who cause
trouble thereby forcing the many merchants who desire
to stay in business but need financial institutions to buy
their consumer credit paper to “now react responsibly
to consumer complaints in order to keep the avenue of
credit open .” 73
Great Britain’s Committee on Consumer Credit ex-
pressed the rationale for abolishing HIDC and waiver of
defense clauses rather simply when it stated:
“If an obligation to repay is incurred in the first
instance to the supplier .... and the right to
receive payment is then transferred to a third
party taking with notice of the fact that the debt
stems from a consumer credit transaction, then we
consider that the third party ought not to stand in
a better position than the supplier himself,
whether the obligation to repay arises under the
supply contract or under a separate promissory
note .” 74
Of all the arguments for abolishing a financial
institution’s freedom from consumer defenses, Professor
Homer Krlpke of New York University, who describes
himself “as a (former) finance company lawyer”, pro-
vides perhaps the best rationale:
“Looking at the matter legislatively, we may ask
who, as between the consumer and financer, ought
to bear the risk of the merchant’s breach of
warranty or delivery of shoddy goods? The con-
sumer sues the merchant only once or episodically.
36
The financer, even though it does not control the
merchant or participate in the breach of warranty,
ordinarily has a continuing relationship with him
and some experience of his performance of war-
ranties. The financer is certainly better equipped
with staff to check the merchant’s reputation for
reliability and fair dealing. It is submitted that the
risk of cases of legitimate customer dissatisfaction
should be thrown on the financer. The financer is
best able to force redress by maintaining an action
over against the merchant or by charging withheld
amounts in the fmancer’s hands, even where his
basic purchase of the obligation from the mer-
chant was without recourse. The financial institu-
tion always protects itself by warranties from the
merchant as to freedom of the obligation from
customer defenses, Moreover, such a rule would
cut-off the sources of credit of a merchant with
repeated bad warranty relations with his creditors.
“The clinching argument is the contrast between
the legal relationships in consumer financing and
the legal relationships in the financing of com-
mercial accounts receivable, In that field the
financing institutions, many of which are also
engaged in the consumer field, have never sought
to extend to the commercial field their assertion
that they are entitled to freedom from customer
defenses. There is one simple reason for this: the
commercial buyers would not stand for it, for the
purchase contracts in the commercial field are not
contracts of adhesion. What then happens to the
question of freedom from defenses in the com-
mercial field? The financer as part of its credit
determination studies the experience of the seller
in respect to customer complaints and returned
goods, and if the percentage is too high, refuses to
do business with that merchant. The same type of
credit thinking would provide the answer in the
consumer field.” 75
With abolition of cutoff devices, it is only logical to
assume that the financing institutions would probably
protect themselves by increasing the dealer reserve (the
percentage of each contract price retained by the
financial institution as a fund against which to charge
bad debts and other credit losses of that particular
dealer) or by decreasing the dealer’s participation (the
dealer’s share of the finance charge) in each consumer
credit transaction. In either case, the ultimate burden of
increased costs to dealers would likely be passed on to
the consumer in the form of higher cash prices for the
goods or services or in the form of higher finance
charges, or both.
The Commission believes spreading the costs of
abolishing third party cutoff devices to all consumers in
the marketplace would be more than counter-balanced
by the protections which the consuming public will
receive in the form of better goods and services.
Moreover, the repercussions will probably not be as
significant as some have suggested. 76 The Commission
agrees with Professor Kripke, when he states:
“In a reputable milieu— reputable merchants, rep-
utable products, reputable fmancers— the freedom
from defense rule is statistically unneces-
sary Its time has run out.” 7 7
The Commission’s recommendation regarding con-
nected loans is intended to prohibit financing institu-
tions and sellers and suppliers of goods and services from
circumventing restrictions on cutoff devices by resorting
to direct loan financing arrangements. Making a con-
nected lender subject to the claims and defenses of
consumers arising in the underlying transaction will
deter interlocking loan arrangements between sellers and
financing institutions intended to afford the financing
institutions the same cutoff devices available with
purchased paper. Lenders will receive no protection
where the seller and lender have a continuing business
relationship in which the seller directs or otherwise
refers the consumer to a particular lender for a purchase
money loan. The recommendation is intended to close
the umbrella of protection which direct loan financing
offers connected lenders.
The Commission has not attempted to define a
connected lender. It has, instead, listed those factors and
incidents of dealing which it deems relevant to any
determination of a continuing relationship between a
vendor and a lender sufficient to establish the connec-
tion.
For tills purpose it should be ascertained whether:
1. The lender supplied forms to the seller, lessor or
supplier of services which the consumer used in ob-
taining the loan.
2. The seller, lessor or supplier prepared or assisted in
preparation of documents used to evidence the loan.
3. The lender is related to or affiliated with the
seller, lessor, or supplier of services.
a. With regard to individuals, “related to” refers
to any familial relationship;
b. With regard to corporations, firms, partner-
ships, trusts, and other organizations, “affiliated
with” refers to (1) direct or indirect control of or by
any such organization, (2) interlocking directorates or
other form of joint or common management of two
or more organizations, or (3) familial relationship
with an officer, director, owner, partner, trustee, or
similar official of an organization.
37
4. The lender directly or indirectly pays the seller,
lessor, or supplier of services, any commissions, fees, or
other consideration measured by or based in any way on
the consumer loan.
5. The lender has knowledge— including knowledge
from dealing with other customers of the seller, lessor or
supplier of services or knowledge from records or notices
of complaints by other such customers-that the seller,
lessor, or supplier of service failed to perform agree-
ments with customers or fails to remedy valid com-
plaints.
6. The lender has repeatedly and regularly made
loans in a 1-year period to finance purchases of goods or
services from the seller, lessor, or supplier of services, or
persons related to or organizations affiliated with the
seller, lessor, or supplier of services, and the lender was
recommended to the consumer for the loans in question.
The Commission believes holding connected lenders
liable for consumer claims and defenses stemming from
■underlying transactions is necessary to the goal of
preserving consumer defenses by abolishing cutoff
devices in purchased paper transactions. 78 The abolition
of cutoff devices should also be extended to credit card
transactions. Where the lender is the issuer of a credit
card which may be used by the consumer in a sale, lease,
or service transaction with the seller, lessor, or supplier
of services, the lender-issuer should be subject to the
customer’s claims and defenses, except in those transac-
tions where the credit card is merely a substitute for
cash(e.g, transactions up to $50).
Any attempt to deal with third party cutoff devices
such as HIDC and waiver of defense clauses involves a
question of balance. The needs of small businessmen to
obtain capital to enter and remain in the market serving
marginal risk consumers must be weighed against the
protection of all consumers. The balance is sometimes a
delicate one. In this case it is not. The Commission
firmly believes that consumers have an absolute right to
receive fair value in the purchase of goods and services.
One way to help achieve this goal is to abolish the HIDC
doctrine and waiver of defense clauses. The inevitable
reduction in availability of consumer credit in some
markets will be more than offset by increased consumer
confidence in the market as a whole.
Levy on Personal Property
This discussion is related solely to post-judgment
collection mechanisms— the enforcement of judgments.
Such enforcement is necessary for the creditor to be able
to collect judgments he Iras obtained.
Today, for the most part, judgments for money or for
possession of property are enforced by writs of execu-
tion just as they were at common law. If it is a money
judgment, the writ of execution authorizes the proper
state officer (usually a sheriff or marshall) to seize any
property (including the home) of the defendant not
exempt by statute from seizure, sell it at an execution
sale, and apply any proceeds derived toward satisfaction
of the judgment. In many states, recordation of a money
judgment also effects a lien on the defendant’s real
property, besides allowing seizure and sale of person-
alty. 79 A judgment for possession of property is
enforced similarly, except that sale does not usually
follow seizure.
Prior to entry of judgment against a debtor arising
out of a consumer credit transaction, while a court may
create a lien on the personal property of the debtor, that
lien should not operate to take, or divest the debtor of
possession of the property until final judgment is
entered. However, if the court should find that the
creditor will probably recover in the action, and that the
debtor is acting or is about to act in a manner which will
impair the creditor’s right to satisfy the judgment out of
goods upon which a lien has been established, the court
should have authority to issue an order restraining the
debtor from so acting. The following property of a
consumer debtor should be exempt from levy, execu-
tion, sale, and other similar process in satisfaction of a
judgment arising from a consumer credit transaction
(except to satisfy a purchase money security interest
created in connection with the acquisition of such
property).
1. A homestead to the fair market value of $5,000
which should include a house, mobile home, or like
dwelling, and the land it occupies if regularly occupied
by the debtor and/or his family as a dwelling place or
residence and intended as such.
2. Clothing and other wearing apparel of the debtor,
spouse, and dependents to the extent of $350 each.
3. Furniture, furnishings, and fixtures ordinarily a fid
generally used for family purposes in the residence of
the debtor to the extent of the fair market value of
$2,500. ■
4. Books, pictures, toys for children and other such
kinds of personal property to the extent of $500.
5. All medical health equipment being used for
health purposes by the debtor, spouse, and dependents.
6. Tools of trade, including any income-producing
property used in the principal occupation of the debtor
not to exceed the fair market value of $1,000.
7. Any policy of life or endowment insurance which
is payable to the spouse or children of the insured, or to
a trustee for the benefit of the spouse or children of the
insured except the cash value or any accrued dividends
thereof.
8. Burial plots belonging to the debtor and/or spouse
or purchased for the benefit of minor children to the
total value of$l, 000.
9. Other property which the court may deem neces-
sary for the maintenance of a moderate standard of
living for the debtor, spouse, and dependents .
The Commission believes that the current system of
having a court establish a lien on personal property of
the debtor prior to a judgment is an acceptable
procedure providing the debtor is not deprived of the
right to retain possession of the property until judgment
is entered. It also believes that widely differing state-by-
state personal property exemptions which now exist do
not adequately protect the debtor, spouse, and de-
pendents and recommends uniform exemptions to en-
sure the necessaries of life to the debtor and the debtor’s
family.
Contacting Third Parties
While communication of the existence of an alleged
debt to a person other than the debtor is not, strictly
speaking, a creditors’ remedy, the Commission con-
sidered it because of its extensive use as a collection
practice. To the Commission’s surprise, almost 48
percent of all creditors surveyed estimated that they
contacted employers and other persons, including
neighbors, from 1 to 40 percent of the time to assist in
debt collection activities. Threats to job security and
application of social pressure are not proper methods to
induce payment of debt. Until such time as a debt has
been reduced to judgment, it should be a private matter
between the debtor and creditor. Any communication
regarding a debt to the debtor’s employer or neighbors
or others without the debtor’s consent is an invasion of
the debtor’s privacy and is not a legitimate collection
practice.
This recommendation in no way is intended to
prohibit a creditor from reporting appropriate informa-
tion about a debt or alleged debt to a credit bureau, or
from employing an agent or attorney to collect the debt.
No creditor or agent or attorney of a creditor before
judgment should be permitted to communicate the
existence of an alleged debt to a person other than the
alleged debtor, the attorney of the debtor or the spouse
of the debtor without the debtor’s written consent.
Miscellaneous Recommendations
Several collection devices and contract provisions
either were not included in the Survey or were included
only in questionnaires to certain creditors. Recom-
mendations regarding these provisions and devices are
based on grounds of public policy and fair dealing and
limited empirical data which the Commission had
available.
Balloon Payment
With respect to a consumer credit transaction, other
than one primarily for an agricultural purpose or one
pursuant to open end credit, if any scheduled payment is
more than twice as large as the average of earlier
scheduled payments, the consumer should have the right
to refinance the amount of that payment at the time it is
due without penalty. The terms of the refinancing
should be no less favorable to the consumer than the
terms of the original transaction. These provisions do
not apply to a payment schedule which, by agreement, is
adjusted to the seasonal or irregular income of the
consumer.
The “balloon payment” presents a potentially serious
problem for the consumer. If a consumer signs a $2,000
note payable in 11 instalments of $150 and a final
instalment of $350, such a payment schedule could lull
him into a pattern of $150 payments. When the final
$350 payment comes due the consumer may not have
properly budgeted for this payment, leaving him the
choice of defaulting or of refinancing the balance due.
Under such pressure, the debtor is most susceptible to an
increase in the APR on the balance. In many cases, a
balloon payment is simply a device to encourage the
refinancing of some portion of a debt often at a rate in
excess of the original rate. The Commission recommends
restriction of balloon payments except when they are
bona fide attempts to arrange payment schedules to
meet the needs of consumers earning irregular incomes.
Co-Signer Agreements
No person other than the spouse of the principal
obligor on a consumer credit obligation should be liable
as surety, co-signer, co-maker, endorser, guarantor, or
otherwise assume personal liability for its payment
unless that person, in addition to signing the note,
contract, or other evidence of debt also signs and
receives a copy of a separate co-signer agreement which
explains the obligations of a co-signer.
The Commission surveyed use of co-signer agreements
by finance companies and credit unions only. Both types
of institutions placed some reliance on the co-signer
agreement as a method of collection, but credit unions
virtually always included such agreements in their
contracts and relied on them as a collection device to a
greater extent than did finance companies. A creditor’s
reference to the liability of a co-signer is often effective
in inducing the primary obligor on the contract to
satisfy the obligation irrespective of the underlying
merits of the claim.
To protect persons who obligate themselves as co-
signers and provide them information necessary for full
496-072 0 - 73 -5
39
understanding of their obligation, the Commission rec-
ommends that co-signers be required to execute separate
co-signer agreements similar to the form required by the
Wisconsin Consumer Act, and that the creditor be
required to furnish a copy of that agreement to each
co-signer. The Wisconsin form reads:
(a) The undersigned as a co-signer or guarantor has agreed
to pay the total of payments under a consumer credit
transaction between (name of
customer) and (name of
merchant) made on (date of
transaction) for (description of purpose
of credit, i.e., sale or loan) in the amount of $
(b) As a co-signei the undersigned will be liable and fully
responsible for payment of the above amount even though he
is not entitled to any of the goods, services or loan furnished
thereunder.
(c) The undersigned may be sued in court for the
payment of the amount due under this consumer credit
transaction even though the customer named above may be
working or have funds to pay the amount due.
(d) This explanation is not the agreement under which
you are obligated, and the guaranty or agreement you have
executed must be consulted for the exact terms of your
obligations.
(signature of co-signer)
Rebates for Prepayment
A consumer should always be allowed to prepay in
full the unpaid balance of any consumer credit
obligation at any time without penalty. In such instances
the consumer should receive a rebate of the unearned
portion of the finance charge computed in accordance
with the "balance of the digits ” (otherwise known as
"sum of the digits’' or “ rule of 78’s” method) or the
actuarial method. For purpose of determining the
instalment date nearest the date of prepayment, any
prepayment of an obligation payable in monthly
instalments made on or before the 15th day following an
instalment due date should be deemed to have been
made as of the instalment due date, and if repayment
occurs on or after the 16th it should be deemed to have
been made on the succeeding instalment due date. If the
total of all rebates due the consumer is less than $1 no
rebate should be required . '
In the event of prepayment the creditor should not
be precluded from collecting or retaining delinquency
charges on payments due prior to prepayments.
In the case of credit for defective goods, the
consumer should be entitled to the same rebate as if
payment in full had been made on the date the defect
' was reported to the creditor or merchant.
If the maturity of a consumer credit obligation is
accelerated as a result of default and judgment is
obtained, or a sale of secured property occurs, the
consumer should be entitled to the same rebate that
would have been payable if payment in full had been
made on the date judgment was entered or the sale
occurred.
Upon prepayment in full of a consumer credit
obligation by the proceeds of credit insurance, the
consumer or his estate should be entitled to receive the
same rebate that would have been payable if the
consumer had prepaid the obligation computed as of the
date satisfactory proof of loss is furnished to the
company.
The Commission believes consumers ought to be
allowed to prepay consumer credit obligations in full at
any time without being subjected to a penalty for such
prepayment. Finance charges earned through the date of
full prepayment should, of course, be retained by the
creditor, but any excess should be refunded to the
customer without penalty or deduction.
Both the balance of the digits and the actuarial
method of rebate computation take into account both
the amount of credit available to the debtor and the
time he lias had use of the funds. For example, if a
debtor borrows $1,200, with a finance charge of $72,
repayable in 12 monthly instalments of $106, his use of
the proceeds of that loan is as follows:
Month
Dollar
Months of Use
1st
1,200
2nd
1,100
3rd
1,000
4th
900
5th
800
6th
700
7th
600
8th
500
9th
400
10th
300
11th
200
12th
100
7,800
If he should prepay the loan at the end of the 4th
month, the debtor would have had the use of 4200
dollar months (1,200+ 1,100+ 1,000 + 900) out of a
total of 7,800 dollar months. Under the balance of the
digits method, the creditor would be entitled to retain
42/78 of the initial finance charge, and the debtor would
receive a refund of 36/78 of that charge. In this
example, the refund to the debtor would be
36/78 X $72 = $33.23
The actuarial method, while computed from actuarial
tables, produces approximately the same result. In the
40
same example a refund under the actuarial method
would amount to $33.63, a difference of only 40 cents.
If the debtor had paid the loan in full after the first
month, the refund due him under the balance of the
digits method of computation would have been $60.92
and under the actuarial method $61.10.
In view of the negligible difference between results of
the two methods, and in view of the existing extensive
use of balance of the digits refund tables, the
Commission recommends the use of either method.
The Commission takes the position that the amount
of the refund is a function of the gross amount of the
precomputed finance charge, irrespective' of whether
that finance charge was computed by application of a
single rate or application of graduated rates (e.g., 36
percent on the first $300 and 24 percent on the
balance). That is, the refund should be computed on the
basis of the total precomputed finance charge and the
total amount being prepaid so that, after rebate of the
unearned finance charge to the debtor, the effective rate
earned by the creditor approximates the disclosed APR.
If goods are defective, the Commission feels quite
strongly that the debtor should be entitled to a rebate of
all finance charges from the date the defect is reported
to either the financing institution or the seller. It is
patently inequitable to exact a finance charge in
connection with a credit purchase of goods if the
consumer is denied use of the goods because of a defect.
Entry of judgment against the debtor and payment of
the obligation from proceeds of an insurance policy have
the same effect as prepayment of the obligation as of the
date the judgment is entered or proof of loss is
furnished. Finance charges are not earned by the
creditor after these events, and the debtor should be
entitled to rebate of the unearned portion of those
charges.
Unfair Collection Practices
The Commission recommends abolition of the
following additional collection techniques without
hesitancy.
Harassment
No creditor, agent or attorney of the creditor, or
independent collector should be permitted to harass any
person in connection with the collection or attempted
collection of any debt alleged to be owing by that
person or any other person.
Harrassment includes, but is not limited to, the
following practices:
1. Threats of violence, express or implied, to the
person or property of any person, or threats to
impair the consumer’s credit standing.
2. False statements or intimations to any person that
a debtor is unwilling or refuses to pay a just debt.
3. Placing telephone calls at unusual times or times
known to be inconvenient, or continuous placing
of calls and repeated engagement of persons in
conversation.
4. Use of obscene or profane language.
5. Threatening to cause the loss of the consumer’s
employment; requesting the consumer’s employer
to require the consumer to pay; making
continuous personal visits to the consumer at his
place of employment so as to interfere with his
employment function.
In the Commission’s view, the above practices are
1 offensive to the conscience of society and should not be
permitted to occur.
Sewer Service
If a debtor has not received proper notice of the
claim against him and does not appear to defend against
the claim, any judgment entered shall be voided and the
claim reopened upon the debtor’s motion.
The systematic practice by process servers (usually
private process servers) of filing an affidavit of service on
the defendant-debtor when, in fact, the summons has
never been served but stuffed in a “sewer” or elsewhere,
should not be allowed to continue. The practice denies
the debtor-defendant proper notice and an opportunity
to defend the underlying claim against him.
Inconvenient Venue
No creditor or holder of a consumer credit note or
other evidence of debt should be permitted to
commence any legal action in a location other than
(1) where the contract or note was signed, (2) where the
debtor resides at the commencement of the action,
(3) where the debtor resided at the time the note or
contract was made, or (4) if there are fixtures, where the
goods are affixed to real property.
Many states permit a suit for money judgment to be
brought in a county where either the plaintiff or
defendant resides. This type of venue provision can easily
be abused by plaintiffs in collection matters. For
example, if the plaintiff-creditor has multiple locations
or a central place of business fairly distant from the
county or location where most of its customers reside, it
can initiate suit in a venue (location) which, though
“legally” proper, is extremely distant from or
inconvenient to the debtor-defendant. The practice
usually results in the entry of a default judgment and, in
effect deprives the debtor-defendant of a reasonable
opportunity to defend against the underlying claim. The
Commission believes the plaintiff-creditor should be able
only to initiate action in locations convenient to the
41
debtor-defendant or in locations where reasonable
grounds exist on which to base the debtor-defendant’s
appearance.
Debtors in Distress
Consumer Credit and Consumer Insolvency
Almost concurrently with the Commission study, the
Commission on Bankruptcy Laws of the United States
has been studying, analyzing, and evaluating the
technical aspects of the Bankruptcy Act as they “are
interwoven with the rapid expansion of credit . . . ” 8 0
This Commission, however, feels compelled to address
itself to areas of consumer credit directly related to the
bankruptcy process.
Perhaps the concept most fundamental to the
Bankruptcy Act is “rehabilitation” of the bankrupt.
Lightening the load of debts is inherent in any
rehabilitative scheme, but, it is questionable whether the
existing bankruptcy system affords the consumer-
bankrupt adequate opportunity for rehabilitation.
Often the existence of one debt out of proportion to
others or incurred because of deceptive sales practices
precipitates bankruptcy. Current alternatives of
“straight” bankruptcy or a Chapter XIII - Wage Earner
Plan may not solve the debtor’s dilemma. He may wish
to pay all of his debts except one fraudulently incurred.
Or he may wish to be able to be discharged from all his
obligations but may subsequently find himself unable to
obtain credit except from a creditor who wants him to
reaffirm his prior debt as a condition for granting new
credit.
The Commission believes that Chapter XIII of the
Bankruptcy Act can be better utilized. While no
inference should be drawn that the Commission is in
favor of “compulsory” Chapter XIII in consumer
bankruptcy situations, it believes that the bankruptcy
courts can play an integral role in the consumer credit
system by providing counseling for the debtor 8 1 and by
helping to resolve debtor-creditor problems which are
particularly acute in our credit-oriented society.
The Commission recommends:
The expansion of Chapter XIII of the Bankruptcy
Act as endorsed by the House of Delegates of the
American Bar Association in July 1971, whereunder
Chapter XIII courts, under certain circumstances, would
be permitted to alter or modify the rights of secured
creditors when they find that the plan adequately
protects the value of the collateral of the secured
creditor.* 2
In petitions for relief in bankruptcy the bankruptcy
court should disallow claims of creditors stemming from
“unconscionable ” transactions.
Bankruptcy courts should provide additional staff to
serve as counselors to debtors regarding their relations
with creditors, and regarding their personal, credit, and
domestic problems.
The Commission believes that Chapter XIII ought to
be opened to persons other than just wage earners.
Chapter XIII is an effective device for encouraging
debtors to pay their debts rather than to seek a discharge
in bankruptcy. In many instances Chapter XIII relief
offers the debtor more lasting benefits than he would
receive in “straight” bankruptcy and helps the debtor
avoid the “stigma” of being adjudicated a bankrupt.
In determining whether a consumer credit transaction
is unconscionable, the bankruptcy court, in addition to
case law, should consider whether the transaction
entailed an “improvident extension of credit.” The court
should, in fact, consider whether the creditor made “an
extension of credit to a debtor where it cannot be
reasonably expected that the debtor can repay the debt
in full in view of the circumstances of the debtor as
known to the creditor and of such circumstances as
would have been revealed to him upon reasonable
inquiry prior to the credit extension .” 8 3
If the bankruptcy court were empowered to disallow
“unconscionable” debts, the bankrupt in his initial
petition need not elect between straight bankruptcy and
a wage earner plan under Chapter XIII, but may just file
application for unspecified relief together with schedules
listing debts and assets. After court review of facts
surrounding the extension of credit, the debtor and his
attorney could consult with the court-appointed
counselor and discuss advantages and disadvantages of
straight bankruptcy or a Chapter XIII plan.
The court appointed counselor could also play a vital
role in any decision of the debtor regarding reaffirma-
tion of a debt affected or discharged by a Chapter XIII
or .straight bankruptcy plan. Since creditors frequently
attempt to obtain reaffirmation of a debt discharged or
affected by a bankruptcy plan , 84 it would be the
counselor’s function to explain the implications of
reaffirmation to the debtor. However, beyond informing
the debtor of his or her rights and/or obligations, the
counselor should have no active role in the decision of
whether or not to reaffirm.
Liability of Corporate Officers
The consumer credit market continues to grow,
unfair practices continue to be used in that market,
particularly in low income areas, and the Commission
perceives an acute necessity for breaking down the
protective barriers which the corporate veil affords the
unscrupulous merchant and creditor. The debtor may
often find himself with an award for damages against a
42
corporation which has been dissolved or is insolvent. Tire
officers, directors, and managers of such corporations,
the individuals who knowingly and wilfully perpetrated
deceptions on the consumer, should be responsible for
the consequences of their acts. They should not be able
to hide behind the shield of the corporation.
Door-to-Door Sales
In any contract for the sale of goods entered into
outside the creditor’s place of business and payable in
more than four instalments, the debtor should be able to
cancel the transaction at any time prior to midnight of
the third business day following the sale.
In this recommendation the Commission accepts the
definition of “consumer credit” contained in regulation
Z section 226.2(k). Recognizing that in a significant
portion of sales occurring outside the creditor’s place of
business, the debtor may be induced to sign a sales
agreement by high pressure techniques, the Commission
believes that many consumers become unwilling
participants to the agreement and should be afforded a
reasonable opportunity to cancel the agreement.
Assessment of Damages
If a creditor in a consumer credit transaction obtains
a judgment by default, before a specific sum is assessed
the court should hold a hearing to establish the amount
of the debt the creditor-plaintiff is lawfully entitled to
recover.
Survey of Consumer Credit Collection
Practices and Creditors’ Remedies
The Commission Survey of all segments of the
consumer credit industry was undertaken with four
objectives:
First: To help the Commission understand practices
normally used in debt collection by all segments of
the industry ;
tractual provisions are most effective in achieving
payment of legitimate debt with the least burden on
the debtor and the creditor.
The following exhibits are summaries of creditor
responses to questions 8, 9, 12 and 16 of the Survey.
These exhibits deal respectively with the major reasons
for default, grace periods, collection procedures and
third party contracts.
EXHIBIT 3-1
MAJOR REASONS CREDITORS CITE FOR
DEBTOR FAILURE TO MEET
CONTRACTUAL TERMS
(Analysis of Q.8)
REASON
BANKS
— —
FINANCE
COMPANIES
RETAIL
TRADE
Unemployment
1
1
1
Overextension
2
2
3
Illness of debtor
3
3
2
Separation
4
4
4
Illness of family
member of debtor
5
6
6
Divorce
6
5
5
Lack of intention
to repay just debt-
"deadbeat"
7
8
7
Family relocation
8
7
8
EXHIBIT 3-2
Second: to compile data establishing the extent and
frequency of use of various alternative collection
practices, creditors’ remedies, and contract pro-
visions;
Third: to document and compare experiences of
various creditors and to further compare experiences
of creditors in states which have restricted or
abolished certain collection devices with experiences
of creditors in those states which have taken no such
action; and
Fourth: to help the Commission determine what
collection practices, creditors’ remedies, and con-
CREDITOR GRACE PERIOD BEFORE
CONSUMER ACCOUNT HELD
DELINQUENT
(Analysis of Q.9)
BANKS
FINANCE
COMPANIES
RETAIL
TRADE
Number of days
before creditor
declares a con-
sumer credit
account delin-
quent.
12.2
16.5
39.4
43
| EXHIBIT 3-3
MOST EFFECTIVE COLLECTION PROCEDURES OTHER THAN LEGAL ACTION
(Analysis of Q. 12)
BANKS
FINANCE
COMPANIES
RETAIL TRADE
Percentage of creditors listing telephone communication
among the most effective.
52
52
70
Percentage of creditors listing personal contact among the
most effective
53
51
28
Percentage of creditors listing letter communication among
the most effective
28
25
44
Percentage of creditors listing referral to collectors among the
most effective
7
6
22
Percentage of creditors listing refinancing of the obligation
among the most effective
5
4
15
EXHIBIT 3-4
CONTACT OF THIRD PARTIES IN EFFORT TO COLLECT CONSUMER CREDIT OBLIGATIONS
(Analysis of Q. 16)
BANKS
FINANCE COMPANIES
RETAIL TRADE
OCG
Direct
OCG
Indirect
Auto
Direct
Auto
Indirect
Personal
Loans
Auto
Direct
Auto
Indirect
Personal
Loans
Revolv-
ing
Instal-
ment
Percentage of creditors
who telephone debtor's
employer
59
55
57
59
56
57
55
49
33
28
Never - 0%
34
34
33
32
34
34
33
38
60
61
Rarely 1-15%
49
49
50
52
48
54
52
46
30
26
Occasionally/16-40%
6
4
6
7
7
1
’ 2
2
3
1
Often 41-70%
.5
.9
.5
.5
.9
0
0
0
0
0
Usually 71-100%
.2
.3
.3
.2
.4
1
2
.5
0
0
Percentage of creditors
who telephone neighbors
and others
41
40
40
43
39
46
46
41
29
29
Never - 0%
48
47
48
48
49
41
45
44
62
57
Rarely 1-15%
36
35
35
38
34
39
37
35
24
28
Occasionally 16-40%
4
4
4
4
4
4
6
5
3
1
Often 41-70%
1
.9
.8
.9
.8
1
3
.5
2
0
Usually 71-100%
.3
.3
.4
A
.3
1
0
.5
0
0
44
Chapter 4
SUPERVISORY MECHANISMS
INTRODUCTION
The Commission considered at length the adequacy
of Federal and state supervisory and regulatory mecha-
nisms to protect the public from unfair consumer credit
practices. For the most part, consumer credit protection
laws require disclosure of credit costs, regulate rates of
credit charges, limit terms of credit agreements, and
restrict practices used by creditors to enforce these
agreements.’ Though a large body of consumer law has
evolved during recent decades, public discontent with
credit problems seems to have risen rather than de-
creased during this period of extensive legislative acti-
vity. A partial explanation of this phenomenon can be
attributed to unsuccessful enforcement of these laws.
In its broad sense, effective enforcement of consumer
credit laws must encompass (1) educating the consumer
on how to stay out of trouble; (2) informing the
consumer of his legal rights under the law; (3) preventing
creditors from abusing consumers; and (4) aiding the
aggrieved consumer once he has been injured. Most
formal enforcement procedures have focused on the
third function of enforcement— supervising and inspect-
ing creditors to deter them from violating credit
laws— while human relations aspects of the first and
fourth functions have been neglected. Since consumer
education is discussed in Chapter 1 1 and legal rights in
Chapter 3, this chapter deals only with the second and
third functions of enforcement.
From a consumer’s standpoint there is no persuasive
reason why the governmental role in enforcing his rights
under credit laws cannot be performed in a uniform,
consistent manner by a minimum number of different
agencies. However, governmental mechanisms for pro-
tecting consumers in the credit arena are incredibly
diverse. Two planes of variables contribute to the
confusion. First, some creditors are extensively regulated
for consumer credit purposes while others are scarcely
touched by regulatory agencies. Second, some creditors
are regulated by Federal authorities, some by state
authorities, some by both, and some, in truth, by
neither.
Much of the complexity in the enforcement of
consumer credit laws today stems from two major
features of American economic life. The first is the dua
banking structure which encompass a national bankinj
system with a strong tradition of independence fron
state control. The second is the existence in most statei
of usury laws with such low rate ceilings that mosi
creditors could not take the risks of granting credit tc
consumers without exceptions from the usury laws.
Under the dual banking system national banks are
regulated only by Federal authorities and, virtually, only
for compliance with Federal laws (violation of state
usury laws was expressly made a violation of Federal
law). Eater, other federally chartered institutions came
into existence-savings and loan associations, credit
unions— similarly independent of state control. Until
passage of the Consumer Credit Protection Act (CCPA)
in 1968, 2 nearly all consumer credit protection law was
state law. Hence, the insulation of federally chartered
institutions from state control meant that much con-
sumer credit law had little impact on Federal institutions
because Federal authorities were largely uninterested in
examining for violations of state laws. State officials
were thought to have only limited rights to impose these
laws on Federal institutions.
Because consumer finance companies could not ex-
tend consumer credit profitably under usury laws, they
appealed to state legislatures for exemption from such
laws. Their bid for higher rates was presented to the pub-
lic and lawmakers as sponsorship of anti-loan sharking
laws, for the dearth of legitimate consumer loans had
left the small loan market to illegal lenders. 3 The price
consumer finance company lenders paid for the privilege
of charging rates higher than allowed by usury laws was
to submit to licensing and heavy administrative control.
The consumer finance industry is still the most heavily
regulated segment of the consumer credit industry.
In contrast, retailers which began extending instal-
ment credit were shielded from usury laws by the
judge-made “time price” doctrine. This doctrine permit-
ted the sale of an article for $100 cash or for a “time
price” of $110 to be paid over 10 months without the
$10 being considered interest under the usury laws. 4
Consequently, retailers needed no legislative authoriza-
tion to grant consumer credit at profitable rates and
came under no substantia] legislative supervision until
45
passage of the retail instalment sales acts after World
War II. By then retail consumer credit was a mature
industry. Whether because of tradition or its enormous
size, in most states retail credit has not been brought
under administrative control similar to that imposed by
the Uniform Consumer Credit Code (UCCC). One of
the more controversial innovations of the UCCC— pro-
mulgated by the National Conference of Commissioners
on Uniform State Laws in 1968 and enacted in six states
by 1972, is its subjection of all retailers to a substantial
degree of administrative control.
In summary, largely for historical reasons, credit
consumers may find skilled administrative personnel
assuring them of their statutory rights when they borrow
money from a licensed lender. But when they buy goods
from a retailer for a comparable finance charge, they
generally find most governmental agencies uninterested
if they have problems and are left to assert their rights
by private suit against the creditor. Similarly, for reasons
rooted in the historical development of the dual banking
system, national bank depositors are guaranteed by
supervisory personnel that the bank remain solvent, but
those who obtain a consumer loan from the same bank
find that supervisory officials have little or no interest in
having that bank comply with state consumer protection
laws. Here again the debtor is left to assert private suit
against the bank.
CONSUMER CREDIT GRANTORS AND THE
ENFORCEMENT MECHANISM
Because historically new credit grantors entered the
market intermittently and credit legislation emerged on
a piecemeal basis, the consumer credit industry has
become highly segmented. Banks, consumer finance
companies, credit unions, retailers, and sales finance
companies perform somewhat different functions and
often are not permitted to compete effectively with each
other. To say that the laws protecting the public in
dealing with these creditors grew along segmented lines
is to state only half the truth, because, the laws were
largely responsible for the segmentation. Even though
many credit suppliers have diversified and now partici-
pate in different segments of the industry, the legal walls
of segmentation still stand.
Deposit Holding Lenders
Commercial and savings banks, savings and loan
associations, credit unions, and some industrial banks are
both consumer credit grantors and recipients of deposits.
The basis of governmental supervision of deposit holding
institutions has traditionally been that of guarding
against failure. 5 Thus the great body of law that has
developed concerning these institutions has been prin-
cipally concerned with preserving their solvency for the
benefit of depositors. Restrictions are commonly placed
on the kinds, amounts, and terms of loans they can
make, and they are periodically examined for possible
fraud or defalcations. Since the 1930’s, depositors have
enjoyed the additional protection of federally sponsored
deposit insurance.
Governments have been loath to rely on competitive
market forces to protect the public in dealing with
depository institutions. Each type of institution is
chartered or licensed by governmental officials with
particular interest in the institution’s capacity to operate
successfully, and, therefore, with interest in the financial
fitness and moral character of those seeking the charter
or license. Chartering power has been used to limit the
number of banks and savings and loan associations
permitted in the market to whatever number of qualified
participants the authorities deem appropriate to meet
community needs.
For the most part, supervision over deposit holding
institutions is exercised by chartering, licensing, or
insuring authorities. Threat of revocation or suspension
of charter or license is considered adequate to compel
compliance with the supervisory agency’s regulations
and applicable law. 6 Until recently, private suits against
banks and savings and loan associations for violations of
governmental regulations have been comparatively rare,
for the individual depositor’s rights are enforced for'him
by the supervisory agency on the theory that the
public— the depositors— “could not and/or should not
look after its own interests.” 7 In addition to its
examination function, much of a supervisory agency’s
activities are instructional and supportive, such as
establishing rules and guidelines to help institution
personnel comprehend and comply with the law.
Nondeposit Holding Lenders
Consumer finance companies are the leading nonde-
posit holding consumer lenders. Before development of
licensed consumer finance companies between 1910 and
1930, the loan shark was probably the most common
source of credit for the wage earner. Loan sharking
prospered because legitimate lenders could not profit-
ably lend to consumer borrowers under the low usury law
ceilings. 8 Social conditions were ideal from about 1880
to 1920 for illegal lenders to flourish, as the rural exodus
to urban America heightened demands for consumer
loans. Since commercial banks were unwilling to enter
the consumer credit market, either because of their
tradition of lending to commercial institutions or be-
cause consumer loans at permissible rates were unprofit-
able, urban America became the illegal lender’s paradise.
46
As early as 1905 the Russell Sage Foundation set out
to attract responsible capital into the consumer finance
field where regulated lenders could make small loans
available to borrowers at reasonable rates. This move-
ment culminated in 1916 in the first draft of the
Uniform Small Loan Act which allowed licensed lenders
to charge rates substantially in excess of the usury laws
for loans of small amounts. Successive drafts of the Act
moved away from free market competition as a protec-
tive force and toward stricter supervisory and regulatory
controls in the form of periodic examination of a
licensee’s activities to ensure his compliance with statu-
tory loan size limits, rate ceilings, and prepayment
refunds. The first draft provided that licenses should be
granted to all who demonstrated financial fitness and
good moral character. By the fifth draft, freedom of
entry was abandoned by allowing licensing officials to
restrict licenses to lending offices which were “to the
convenience and advantage of the community”— a vague
and never-defined term which, predictably, was inter-
preted with widely differing results in various jurisdic-
tions. 9
Because consumer finance companies have no depos-
itors, their administrative supervision is directed toward
protecting the consumer borrower. Periodic examina-
tions are required, and annual reports are prescribed. It
is fair to say that in most states operations of consumer
finance companies are intensively supervised by adminis-
trative officials charged with enforcing small loan laws.
Supervisory agencies take pride in compelling refunds to
consumers of even the smallest overcharges.
A basic premise of small loan laws has been the
concept of the “all-inclusive” finance charge- for rate
ceilings purposes the consumer finance company must
include in the finance charge all, or almost all, charges
imposed on the debtor as a condition of obtaining
credit. This is in sharp contrast to the legal position of
another class of lender, often referred to as the “second
mortgage lender” because of their custom of taking
junior security interests in real property. Favorable
judicial decisions allowed second mortgage lenders to
make substantial credit-related charges which were not
considered interest under the usury laws. In effect,
second mortgage, lenders could exact credit charges as
high or sometimes higher than those imposed by licensed
lenders. In many states they can still do so with no
administrative supervision. Thus, the borrower seeking a
personal loan may be presented with an astonishing
choice: he can borrow from a licensed lender and enjoy
heavy administrative protection, or he can borrow the
same amount of money on the security of his home at a
rate as high or higher from an unregulated lender. The
consumer’s only remedy for an overcharge in the latter
case may be to hire a lawyer and bring a private law suit
to attempt to show a violation of the state usury law.
Retailers and Their Assignees
Had the courts decided that usury laws were intended
to apply to sales credit as well as loan credit, credit
selling might have become as highly regulated as the
consumer finance industry. However, the “time-price
doctrine” enabled sellers to offer instalment credit with-
out seeking legislative exemption from usury laws. So
long as the time-price doctrine went unchallenged for
retail instalment sales, sellers had little need for legisla-
tion in the credit area. In most states, legislation on
vendor, unlike that on lender, credit was a long time in
coming. Not until tine late 1940’s when credit selling had
already become a mature business did credit legislation
begin to appear in volume. 1 0
Early statutes were legislative reactions to specific
abuses. The first to receive widespread legislative atten-
tion was the failure of some sellers to make adequate
disclosure of significant aspects of retail instalment
credit sales. In some cases the buyer might not have been
told the total amount he owed, might not have received
a copy of the contract he signed, or he might have signed
a substantially blank contract. Lack of disclosure
enabled the unscrupulous seller to burden the buyer
with exorbitant credit charges. Because of the relative
size and importance of consumer credit extended to
finance automobile sales, the first retail instalment sales
acts were almost entirely devoted to motor vehicle
transactions. They usually required that the contract
clearly disclose all terms of the agreement and that the
buyer be given a copy of the contract. Certain unfair
contract provisions were expressly prohibited; the seller
was forbidden to allow the buyer to sign a contract
containing blank spaces; and some, but not all, set rate
ceilings. A number of states enacted similar statutes to
cover instalment sales of goods other than motor
vehicles-the so-called “all-goods” acts. As retail selling
continued to grow and additional abuses appeared,
several states enacted more detailed instalment sales acts
to deal specifically with problems arising from insurance,
add-on or consolidated sales, unfair contract provisions,
the transferee’s position in relation to the buyer, default
and deferral charges, and refinancing.
At present the crucial difference in enforcement of
legislation between lenders and retailers is tire degree of
administrative control. As already noted, lenders such as
banks and consumer finance companies have been
subjected to chartering or licensing with substantial
administrative supervision, some directed at protecting
depositors and shareholders (banks, credit unions) and
47
some at protecting consumer-borrowers (consumer
finance companies). But retail credit statutes normally
vest no administrative officer with power to supervise or
examine credit sellers.
Violations of the typical retail instalment sale act are
met only by penalties (e.g., twice the amount of the
finance charge) that an aggrieved consumer may obtain
by bringing a private law suit against the creditor. 1 1 The
absence of any administrative control on behalf of the
consumer means that retail credit laws are largely
enforceable only by the victims of those who violate
these laws. Surely legislators cannot expect consumers
who are so poor and ingenuous as to be victimized in
credit sales transactions to be wealthy and sophisticated
enough to initiate and fight a lawsuit to a successful
conclusion against usually well-financed creditors. One
of the first statutes to propose administrative control of
credit sellers is the UCCC which, at present, has been
enacted in Colorado, Idaho, Indiana, Oklahoma, Utah
and Wyoming. 1 2
Motor vehicle and appliance dealers commonly dis-
count their consumer contracts with sales finance
companies or commercial banks. More than half the
states have some form of licensing for sales finance
companies. These acts usually define a sales finance
company as one engaged in acquiring instalment con-
tracts from retailers. Two differences distinguish licens-
ing of sales finance companies from that of consumer
finance companies. In sales finance licensing the conveni-
ence and advantage test is not used to limit the number
of participants, and administrative supervision is lighter
than that imposed on consumer finance licensees.
Some acts set character standards for sales finance
licensees. Banking institutions and other supervised
lenders are often specifically exempted from coverage.
Annual reports and mandatory yearly inspections usu-
ally are not required. The administrator is given investi-
gatory and subpoena powers to determine whether
licensees are violating the instalment sale acts. Aggrieved
buyers can file written complaints with the adminis-
trator detailing alleged violations and the administrator
can investigate these complaints and hold hearings. The
administrator can usually suspend or revoke the license
issued under the statute if the licensee has knowingly or
without exercise of due care violated the instalment sale
act.
In several states a retailer is covered by the sales
finance company licensing act if he retains a given dollar
amount of his instalment paper. For instance, the New
York act defines “sales finance company” as including
“a retail seller of motor vehicles engaged, in whole or in
part, in the business of holding retail instalment con-
tracts acquired from retail buyers, which have aggregate
unpaid time balances of twenty-five thousand dollars or
more at any one time ...” In a few states a retailer
may be considered a sales finance company without
regard to dollar amounts if he retains his own paper.
SUPERVISORY FUNCTIONS OF FEDERAL
AND STATE AGENCIES
Most consumer credit is held by creditors currently
subject to supervision in some form. To determine
whether existing supervisory and regulatory mechanisms
are adequate to protect the public from unfair practices
and insure the informed use of consumer credit, the
Commission studied the supervisory functions of major
Federal and state agencies having jurisdiction over
extenders of consumer credit. First, the Commission
considered those functions which historically have been
tlie primary concern of the regulators, Then it attempted
to determine whether the various Federal and state
supervisors were willing and able to examine for compli-
ance with and to enforce consumer credit protection
laws. Although the Commission avoided assessing the
adequacy of general supervision over financial institu-
tions, it was still necessary to look into it, because
consumer credit protection activities are almost always a
part of the general supervisory and examination func-
tion. However, its resultant findings and recommenda-
tions are restricted to the special area of consumer credit
protection.
Federal Agencies
Office of the Comptroller of the Currency
In 1863 Congress passed the National Currency Act
which created the national banking system and estab-
lished the Office of the Comptroller of the Currency.
That Act was superseded the following year by the
National Bank Act which continued the national bank-
ing system administered by the Comptroller. The Comp-
troller’s office has authority to grant charters to national
banks, authority to issue regulations to provide for “the
proper regulation and supervision of the operations of
national banks,” 13 and the responsibility to examine
every national bank twice in each calendar year. 14
On June 30, 1971, the Comptroller’s office had ad-
ministrative and supervisory responsibilities over 4,599
banks with 12,946 branches. Although the Comptroller’s
supervisory responsibilities applied to a minority of the
total number of banks in the country, those banks
accounted for approximately 60 percent of all commer-
cial bank deposits. National banks, as of June 30, 1971,
had approximately $183,7 billion outstanding in all
48
types of loans. Of this amount approximately $40.7
billion was outstanding in direct and indirect consumer
credit, including credit card transactions.
At the heart of the Comptroller’s power to charter
banks is the concomitant power to examine to ensure
that the bank’s activities are conducted in a safe and
sound manner in compliance with applicable law and
with the Comptroller’s Regulations and Rulings. This
view is succinctly expressed on page 1 of the Comptrol-
ler’s Handbook of Examination Procedure:
All facets of bank examination, ranging from apprais-
ing assets and internal controls to evaluating the
soundness of management policies, have as their end
result the determination of liquidity and solvency-
present and prospective-and the legality of the
bank’s acts.
First Deputy Comptroller of the Currency,
Justin T. Watson, stated at Commission hearings in
June 1971 that the Comptroller’s office “since 1913 has
been primarily concerned with tire protection of the
liquidity and solvency of the country’s national banks.”
In addition to authority to examine every phase of a
national bank’s activities, the Comptroller’s office has
the extraordinary power to issue cease and desist orders
under the Financial Institutions Supervisory Act of
1966.' 5 These orders, after notice of charges and a
hearing, may issue if in the Comptroller’s opinion the
national bank:
is engaging or has engaged, or the agency has
reasonable cause to believe that the bank is about to
engage, in an unsafe or unsound practice in conduct-
ing the business of such bank, or is violating or has
violated, or the agency has reasonable cause to believe
that the bank is about to violate, a law, rule, or
regulation, or any condition imposed in writing by
the agency in connection with the granting of any
application or other request by the bank, or any
written agreement entered into with the
agency .... (emphasis added).
This extraordinary grant of power also enables the
Comptroller’s office to suspend or remove a director or
an officer of a national bank for cause.
The force behind the supervisory and administrative
activities of the Comptroller is the specter of loss of
charter, loss of insurance, and loss of membership in the
Federal Reserve System unless the bank complies with
all applicable laws, rules and regulations.
Federal Reserve System
In addition to its primary functions of developing and
implementing monetary policy and management, and
addressing itself to problems of international banking
and finance, the Board of Governors of the Federal
Reserve System (FRB) is also a bank regulatory agency,
empowered to examine the accounts, books and affairs
of each of the 12 Federal Reserve Banks and each
member bank. The FRB, either directly or through the
Federal Reserve Banks, performs other activities, such as
discounting, currency issue and redemption and clearing
house functions.
All national banks are required to be members of the
Federal Reserve System, but state bank membership is
elective. If a state bank wants to become a member, it
must satisfy certain reserve and capital requirements and
purchase stock in their district Federal Reserve Bank.
Once admitted into the Federal Reserve system such
banks are known as “state member banks” and are
automatically admitted as members of the Federal
Deposit Insurance Corporation.
The fundamental statutes governing the chartering of
state member banks are of state origin. Nevertheless, the
activities of the banks are significantly affected by
Federal laws and FRB regulations, with which compli-
ance is a condition of Federal Reserve System member-
ship.
On June 30, 1971, 1,138 state member banks with
3,713 branches held approximately one-fourth of all
commercial banks deposits and had approximately $65.3
billion outstanding in loans and approximately $11.4
billion outstanding in direct and indirect consumer
credit, including credit card transactions. The FRB has
supervisory responsibility over fewer banks than the two
other Federal bank regulatory agencies, but many of
these are large banks in major financial centers. The
average size of a bank subject to FRB supervision is
considerably larger than the average bank under FDIC
supervision.
State member banks are subject to supervision and
examination by the state which chartered the bank as
well as by the FRB. Although national banks are also
members of the Federal Reserve System, dual examina-
tions are avoided because the FRB defers to the
Comptroller for examination.
Most of the examination functions of the FRB are
carried out by the 12 Federal Reserve Banks, where the
principal concern like that of the Comptroller is to
maintain a safe and sound banking system. The FRB,
like tlie Comptroller’s office, has extraordinary power to
issue cease and desist orders and to remove officers or
directors. A major reason for passage of the Federal
Reserve Act in 1913 was “to establish a more effective
supervision of banking,” 16
Federal Deposit Insurance Corporation
The Federal Deposit Insurance Corporation (FDIC)
was created by Congress in an amendment to the Federal
49
Reserve Act by the Banking Act of 1933, 17 “to
promote the soundness of banking and to aid the
government in discharge of its fiscal transactions.” 18 Its
primary function is to “insure. . .the deposits of all
banks which are entitled to the benefits of insurance
under this chapter....” 19 The FDIC has fulfilled its
legislative purpose by protecting bank depositors and
maintaining public confidence “in the Nation’s money
supply in the event of bank failure.” 20 A paper prepared
by George J. Benston of the University of Rochester for
the President’s Commission on Financial Structure and
Regulation indicated that the average annual number of
banks closed per 100 banks operating at the beginning of
the year went from .32 between 1934 and 1942 to .04 1
between 1963 and 1970. 21 Similarly, the annual average
loss on deposits per $100 of deposits in operating
insured banks at the beginning of the year declined from
$.0060 between the 1934 and 1942 period to $.0010
between 1963 and 1970. 22
A report prepared by Carter Golembe for the Na-
tional Association of Supervisors of State Banks, also
attested to the FDIC’s excellent record in protecting the
public against bank failure. It noted that:
Within the last several decades the FDIC has taken
on more of the coloration of a bank supervisory
agency because of the fact that its insurance activities
(though not its responsibilities) have dwindled to
insignificant proportions. With bank failures during
the past decade averaging less than 6 per year
(compared, say, with approximately 500 per year
during the 1920’s) the insurance operations of the
FDIC— while still of immense importance to individu-
als and communities concerned-do not bulk large in
that agency’s activities. 23
Indeed, the 1971 Annual Report of the FDIC disclosed
that on December 31, 1971, less than 9 percent of all
employees were involved in the Division of Liquidation
and that 1,908 of all 2,607 employees were utilized by
the Division of Examination. 2 4 Since its establishment
nearly 40 years ago, the FDIC’s examination function,
initially only incidental to its major insurance function,
has become the agency’s predominant activity.
State nonmember banks (non-Federal Reserve mem-
bers) may apply to the FDIC for insurance coverage. If
certified for insurance, they are known as insured state
nonmember banks and are subject to FDIC examination
authority. To carry out its supervisory and examination
responsibilities, the FDIC divided its examination force
into 14 regional offices, with each office responsible for
regularly examining insured state nonmember banks in
its region. The agency has power to examine all the
affairs of the bank.
The FDIC may examine any insured bank for
insurance purposes, but to avoid duplicating the activity
of other Federal bank supervisory agencies, it uses
examination reports from the Comptroller of the Cur-
rency and the FRB to determine whether national and
state member banks are worthy to continue as insured
banks. 25
Although the FDIC may accept the report of any
agency supervising a state nonmember bank, thus
far— except for some states with which it engages in
joint examination— the agency has preferred to conduct
its own examinations. At Commission hearings FDIC
Chairman Frank Wille stated that “the objective of our
examination and supervisory efforts with respect to state,
nonmember banks has always been to promote safe and
sound banking conditions and practices in conformity
with applicable law. To this end we regularly examine
each such bank seeking to determine its financial
condition.”
Indeed, the FDIC has assumed many of the functions
of a regulatory agency. The decision to accept or reject
an application for deposit insurance for a new bank is
analogous to the granting of a charter, for, in a modern
insurance conscious society, a bank is unlikely to open
without deposit insurance. 26
The number of insured state nonmember banks
examined by the FDIC is greater than the combined
total of national and state member banks examined by
the Comptroller and FRB.
On June 30, 1971, FDIC’s examining function ex-
tended to 7,819 state nonmember banks as compared
with 5,737 national and state member banks. Most state
nonmember banks were “typically of small size” and
comprised only “about 18 percent of all commercial
bank deposits.” 2 7
The FDIC, like the Comptroller and the FRB, has the
extraordinary power to issue cease and desist orders, and
under the Financial Institutions Supervisory Act of
1966, is authorized to institute termination of insurance
proceedings against an insured bank. If after hearing, an
unsafe or unsound practice or violation has been
established and not corrected within the specified time,
the Corporation “may order the insurance terminated at
a date subsequent.” While the power to terminate
insurance provides the FDIC with the mechanism to
protect its insurance fund, it also puts the agency in the
unique position of being able to induce insured banks to
comply with all applicable laws, rules, and regulations.
Federal Home Loan Bank Board
Preston Martin, Chairman of the Federal Home Loan
Bank Board (FHLBB), described that agency’s major
function as “exercising its regulatory authority over a
major force for housing in our economy, the savings and
loan industry, an industry with $181 billion in
assets.” 28
50
The Federal Home Loan Bank System was created to
provide credit reserves for savings and home-financing
institutions. The FHLBB 'charters, examines, and super-
vises federal savings and loan associations under the
provisions of Section 5 of the Home Owner’s Loan Act
of 1933. In addition, it directs the Federal Savings and
Loan Insurance Corporation (FSLIC) as mandated by
Title IV of the National Housing Act, to insure the
safety of savings in thrift and home-financing institu-
tions, In effect, the FHLBB does for savings and loan
associations what the FRB, the FDIC, and the Comp-
troller of the Currency together do for commercial
banks. 29
The diverse examination functions of the FHLBB are
performed by "the Office of Examination and Supervi-
sion through 12 field districts. The purpose of examina-
tion is to prevent the default of federally chartered or
state insured associations.
The majority of loans made under .jurisdiction of the
FHLBB are mortgage loans on residential property,
amounting to approximately “$146.1 billion or more
than 99 percent of all loans made by all insured
institutions.” 30 Of the remaining $1.2 billion, unsecured
property improvement loans account for $667.4 million
and unsecured educational loans for $170.6 million.
The extraordinary powers bestowed on Federal bank-
ing agencies to issue cease and desist orders and remove
officers and directors for cause were also granted to the
FHLBB with regard to insured Federal and state savings
and loan associations. In addition the FHLBB may
initiate suit to enforce the provisions of the Home
Owners Loan Act, “rules and regulations made thereun-
der, or any other law or regulation.”
National Credit Union Administration
In 1970 the National Credit Union Administration
(NCUA) 3 1 was established as an independent agency in
the executive branch of the Government. The NCUA
replaced the Bureau of Federal Credit Unions of the
Department of Health, Education, and Welfare as
the agency responsible for supervising Federal credit
unions.
On June 30, 1 97 1 , the NCUA had administrative and
supervisory responsibilities over 12,956 Federal credit
unions with appropriately $7 billion in consumer loans
outstanding (including approximately $1 billion in real
estate related loans).
The NCUA has the power to grant Federal charters to
credit unions after determination of the character and
fitness of the subscribers, and the economic advisability
of establishing the proposed credit union. The Adminis-
trator of the NCUA is also empowered to conduct
examinations and prescribe rules and regulations neces-
sary for proper administration of such credit unions.
In addition, the Administrator is required to “insure
the member accounts of all Federal Credit Unions” and
may insure, on approval of application, the member
accounts of state chartered credit unions. Each Federal
credit union is required to apply for insurance of
member accounts. If the insurance application of a
Federal credit union is denied, “the Administrator shall
suspend or revoke its charter unless, within one year
after the rejection, the credit union meets the require-
ments for insurance and becomes an insured credit
union.”
The examination powers of the Administrator under
the share insurance provisions are similar to those of the
FDIC and other chartering entities. The Administrator
has power to examine all affairs of the credit union to
ensure that its financial condition and policies are not
unsafe or unsound.
The NCUA, like other Federal financial regulatory
agencies, has the authority to issue cease and desist
orders if unsafe or unsound practices are found in
examination of the business of the credit union or if the
credit union “is violating or has violated or the Adminis-
trator has reasonable cause to believe that the credit
union is about to violate a law, rule or regulation or any
condition imposed in writing by the Administrator.” In
addition, the NCUA has power to terminate share
insurance to protect its insurance fund.
As with other Federal financial regulatory agencies,
primary focus of NCUA’s examination is devoted to
guaranteeing sound operation of the financial institu-
tions under its jurisdiction.
State Agencies
There may be as many different ways in which state
and territorial agencies and departments charged with
enforcing consumer credit laws administer their primary
supervisory and regulatory functions as the country has
states and territories.
Banking Departments
The functions of state banking departments are best
compared with those of the Comptroller of the Cur-
rency. Like the Comptroller, state banking departments
have power to charter banks and examine them periodi-
cally. In conducting examinations, most departments
have full access to all state bank records and power to
subpoena necessary records or witnesses.
In many states, banking departments are not the
highest authority on supervisory decisions. “Almost
three-fifths of the states have banking boards, which in
turn may have powers ranging from advisory to direct
supervision decisions.” 32 Many banking departments are
not independent units of state government but divisions
51
of larger goverment units or individual agencies operat-
ing under the general direction of a state-level cabinet
officer.
The ultimate purpose of bank examination at the
state level is to protect the public interest and prevent
bank failure. The focus of state examination, like
examination by Federal agencies, is to ensure bank
soundness.
Most state banking departments, however, have super-
visory responsibilities far exceeding those entrusted to
the Comptroller of the Currency and other Federal
banking agencies. State banking department supervision
extends to a varied range of nonbank financial institu-
tions and activities. Often the scope of supervision
includes state chartered credit unions, personal or
consumer finance companies, and savings and loan
institutions.. In addition, banking department responsi-
bilities may encompass supervision of safe deposit
companies, industrial loan companies, mutual savings
banks, pawnbrokers, money order companies and even
the general credit granting community (see Exhibit 4-1).
Nonbanking Financial Institutions
Supervisory responsibility for nonbanking financial
institutions may be placed in either:
1 . a division within a state banking department;
2. an independent agency with total supervisory
responsibility; or
3. a part of a statewide financial institutions depart-
ment, with oversight responsibility for all financial
institutions, banking and nonbanking.
Savings and Loan Associations and Credit Unions.
State supervision of state savings and loan institutions
and credit unions resembles that of the FHLBB and
NCUA over federally chartered institutions. 3 3 The state
has power to charter and examine the institutions
periodically for soundness to protect the members’ or
depositors’ interests.
Mutual Savings Banks. Supervision of mutual savings
banks, in the few states in which they are located, is
virtually identical to state banking department supervi-
sion. of commercial banks, both in purpose and purview.
Consumer Finance Companies. In most states, the
department responsible for supervising consumer finance
companies operates under provisions of a state small
loan law which is usually patterned after the Uniform
Small Loan Law. Regulation of the consumer finance
industry, unlike that of other financial institutions, is
directly related to consumer credit protection.
Under the Uniform Small Loan Act, the supervisory
agency performs a three-fold function.
First, it must determine whether an applicant quali-
fies for a license to make small loans. 3 4
Second, after granting a license the supervisory
agency is authorized to examine the books and records
of licensees at least once a year for compliance with
provisions of the law. This examination is intended to
eliminate trickery, fraud, and oppressive collection
practices which prevailed in the small loan market before
the law was passed. If the agency finds the licensee
violating, threatening to violate or intending to violate
the law or its regulations, it may order the licensee to
cease and desist and may seek court assistance to enjoin
the activity.
Finally, the agency has the power to adopt rules and
regulations necessary to provide the administrative
machinery necessary for effective enforcement of the
law.
The agencies that supervise personal finance com-
panies often are also responsible for enforcing other
legislation such as discount and industrial loans laws.
Frequently these are hybrid laws intended to accomplish
varied goals; often they serve to supplement small loan
legislation by permitting larger loans than are allowed
under the small loan law. 35 These additional laws,
however, do not typically provide the consumer the type
of regulatory protections afforded by most small loan
acts.
Other Nonbanking Financial Institutions
In many states the agency charged with licensing
responsibility for the small loan industry is also charged
with licensing businesses engaged in purchasing instal-
ment sales contracts from retail sellers. The scope of
supervision over such institutions, however, is much
narrower than that authorized by the small loan laws. In
fact, “the supervising powers of state agencies under
such provisions (licensing) are usually limited to adminis-
tering the licensing requirements of the act, and are not
expanded to include general responsibility for adminis-
tering provisions of the entire retail instalment sales
act” 36 or other consumer protection laws. Thus, the
function of licensing businesses engaged in purchasing
instalment sales contracts, in most states, is limited to
making “a record of those engaged in such business
activity. . .and to prevent unlicensed operations.” 3 7
Offices of the Attorneys General
At the state level attorneys general have wide-ranging
responsibilities in protecting citizens. The attorney
general, in effect, is the attorney for the state and its
citizenry in civil, administrative, constitutional, and
criminal matters (see Exhibit 4-2). Many are active in
areas of environmental and consumer protection as well
as in combating crime. 3 8
52
The function of attorneys general in the area of
consumer protection includes the prevention of all
fraudulent, deceptive and unfair selling practices which
may or may not involve extensions of consumer credit.
Unlike the financial regulatory agencies, attorneys gen-
eral have no general supervisory or examination powers.
Instead, they must rely on complaints as the catalysts
for their investigative and enforcement activities. 39
Adequacy of Consumer Credit Protection
Specific agency responsibility in the area of consumer
credit protection ranges widely. It can extend from
examining for and enforcing compliance with the Truth
in Lending Act—at the Federal level and in the five
exempted states 40 -to enforcing a host of state laws
which govern :
entry into the credit granting field in the first
place,. . .compliance with rate structures, . 1 .ensuring
compliance with rebate, default and credit life insur-
ance provisions, as well as guaranteeing that restric-
tions on remedies such as repossessions, deficiency
judgment and holder in due course are complied
with. 41
The Commission first examined the consumer protec-
tion activities of the Federal financial supervisory
agencies as they related to state consumer credit
protection legislation. Then it examined state agency
activities in the same area. Finally, the Commission
reviewed the performance of the Federal agencies and
four of the five exempted states in fulfilling their
responsibilities under TIL. (At the time, Wyoming had
not been granted an exemption by FRB.)
The Commission considered the role of all financial
supervisory agencies involved with consumer credit
protection. Its evaluation of agency performance was
based on the following premises:
1. Consumer credit protection laws were intended to
protect equally all the citizens of a state or of the
United States.
2. The degree of this protection should not depend
on whether the consumer deals with a Federal or a
state chartered institution.
3. All agencies, state and Federal, responsible for
examining state chartered institutions should
conduct examinations designed to ensure com-
pliance with applicable law, including state con-
sumer credit protection legislation.
4. Any agency which lacks either the resources or
inclination to perform its supervisory respon-
sibilities adequately should improve its capability
to the point where such duties can be adequately
discharged or have its responsibilities assigned to
another agency for effective performance.
The Commission believes that the Financial Institu-
tions Supervisory Act of 1 966 provides Federal agencies
with the authority and power to require financial
institutions under their jurisdiction to comply with all
applicable laws, including existing state consumer credit
protection Jaws,
In fact, the Financial Institutions Supervisory Act
provides two alternative bases for enforcing consumer
credit protection laws. Section 1464, 1786 and 1818 of
Title 12 of the United States Code authorize the
FHLBB, the Comptroller of the Currency , the FDIC and
the FBR respectively, to issue cease and desist orders if a
savings and loan or bank under their jurisdiction:
is engaging . . . has engaged or the agency has reason-
able cause to believe ... is about to engage in an un-
safe or unsound practice, or is violating . . . has vio-
lated or the agency has reasonable cause to believe ... . .
is about to violate a law . . . (emphasis added).
Since violations of state consumer credit protection laws
may not necessarily threaten the soundness of the
financial institution, even in light of potential class-
action litigation, the argument lias been made that the
agencies are not authorized to act under this provision.
However, the Commission notes that the Financial
Institutions Supervisory Act of 1966 is drafted in the
disjunctive and that violations of law are per se an
adequate basis for agency action irrespective of the
possible impact of the violations on institutional sound-
ness. 42
Bank Supervision
At both Federal and state levels, bank examinations
focus on the soundness of bank activities. 43 This view is
supported in a study of state bank supervision by Carter
Golembe who stated ‘It is quite apparent that the large
majority of state banking departments are acting very
much as if they were insuring agencies.” 44 By conduct-
ing examinations directed toward ensuring bank sound-
ness, state examining forces are generally duplicating
efforts of the FDIC and the FRB with regard to insured
nonmember and state member banks, respectively. In
terms of manpower 1,581 FDIC examiners and 520 FRB
examiners check for soundness the same banks which are
also examined for soundness by 1,541 state banking
department examiners. 45 Thus it would appear that
1,541 state examiners are duplicating work performed
by 2,101 Federal examiners (see Exhibits 44, 4-5, and
4-8). Overemphasis on soundness leaves other bank
supervision functions, such as detection of fraudulent
and irregular consumer credit practices, a poor second in
the scale of priorities 46 and appears to be “an improper
allocation of the limited resources available in the area
of bank supervision generally.” 4 7
53
The extent of apparent duplication in the bank
examination process is difficult to measure because
“some states have either lacked the resources or
inclination to do an adequate job of bank supervi-
sion.” 4 * Professor Benston’s paper on bank examination
maintained that states “as chartering agencies ... are in
much the same position as the Comptroller of the
Currency, with one very important exception, their
staffs and budgets are, in general, inadequate for the task
of effective bank examination. The National Association
of Supervisors of State Banks (now the Conference of
State Bank Supervisors) in 1968 rated 35 states as
inadequate in staff and 1 6 states inadequate in budget
for bank supervision.” 49 In such states it is clear that
Federal bank supervisory agencies cannot be expected
to accept state examination reports without independent
Federal examination. Nonetheless, it is likely that the
state agencies will direct whatever energy and funds they
possess toward examining for soundness and ignore
other matters such as detection of consumer credit
protection law violations.
Federal supervisory agencies fail to supplement state
activities in the areas of other supervisory respon-
sibilities. At Commission hearings in 1971, FDIC’s
Chairman Wille stated that the FDIC “traditionally
tended to limit our special concern to enforcement of
state banking law, that is, those state laws peculiarly
applicable to banks and designed in large measure to
assure the safe and sound operation of those banks.” He
explained that these were “laws dealing . . . with re-
quired reserves and loan limits based on bank capital or
on the value of property taken as security.”
Governor J. L. Robertson, Vice Chairman of the
Board of Governors of the Federal Reserve System,
wrote the Commission that it has been the Board’s
“general policy, as part of our interest in joint federal-
state efforts, to protect the liquidity and solvency of
state banks subject to Federal Reserve supervision. But it
seems clear that the primary responsibility for the
enforcement of state laws with respect to institutions
chartered by the staie rightly lies with the state
authorities, and that the informal assumption of that
primary responsibility by the Federal Reserve authorities
would not be in the National interest.” 5 0
First Deputy Comptroller of the Currency Watson
testified before the Commission that the Office of the
Comptroller “like most other federal agencies, is pri-
marily concerned with enforcement of federal laws.”
Stating that the Comptroller’s “statutory mandate or
authority to enforce directly any state statute or
regulation is limited,” he acknowledged that Section 85
of Title 12 of the United States Code limits the
permissible rate of interest charged by national banks to
‘’the amount allowed by the laws of the State where the
bank is located.” However, this is a restriction on the
conduct of national bank business imposed by the
Federal— not state— lawmakers.
The Deputy Comptroller conceded that “contracts of
national banks, like those of any other lender are subject
in most respects to the law of the jurisdiction in which
the contract is made.” He recognized that many states
have statutes providing special protection for consumer
borrowers, but said that compliance with such provisions
could be effectuated by competition between national
banks and state lenders. He made no mention of the
Comptroller’s intent to examine for or enforce com-
pliance with such laws.
These comments indicate that the Comptroller of the
Currency, the FDIC, and the FRB view their respon-
sibilities in bank supervision as virtually limited to pro-
tecting the solvency and liquidity of the nation’s banking
systems and not to protecting the public from violations
of state laws which on their face seem unrelated to
solvency. The Comptroller’s failure to examine for and
enforce such consumer protection laws is particularly
serious because the Comptroller’s office is the sole
regulatory and supervisory authority for national banks.
The FDIC and FRB defer to the Comptroller, and state
agencies have no power to examine national banks. Such
banks are not bound by state laws which “infringe on
the national banking laws or impose an undue burden on
the performance of the banks’ functions;” 5 ! however,
the Commission is convinced that state consumer credit
protection laws do not fall into such a category. As far
back as 1880, the Supreme Court found that the
national banking laws did not evidence a Congressional
intention to exempt national banks from the ordinary
rules of law affecting the legality of actions founded on
local matters. 52 If the Comptroller fails to examine for
and enforce compliance of state consumer credit protec-
tion laws, national bank customers may be denied
protections afforded customers of a state chartered bank
next door, and citizens of the same state could unknow-
ingly be covered by different standards of consumer
credit protection. The Commission considers differing
consumer credit protection standards to be inequitable.
While the Comptroller of the Currency, the FDIC,
and the FRB appear to have adequate resources and
determination to satisfy their primary responsibilities in
guaranteeing a safe and sound banking system, the
matter of consumer protection appears largely to be
neglected at the Federal level. All three Federal banking
agencies have instituted examination procedures
designed to detect violations of the Truth in Lending
Act— a Federal statute. But those violations are only the
“tip of the iceberg” in the sea of consumer protection.
Basic substantive consumer rights which are largely
matters of state law appear to be of minimal concern to
54
Federal banking agencies, if, indeed, they are any
concern at all.
Savings and Loan Associations
Just as with bank supervision, most emphasis and
effort in examination of savings and loan associations are
directed toward soundness. Here again Federal and state
examiners duplicate each other’s work, largely for the
same reason that is responsible for duplication in bank
supervision— the insurance of accounts or deposits thus
giving both the chartering agency and the insuring
agency an interest (only 211 out of 2,440 state
chartered savings and loan associations are uninsured). In
states where the FHLBB acts as the insuring agency,
2,250 state chartered savings and loans with 2,220
branches are examined for soundness by FHLBB and
state examiners, to the extent that an adequate state
examining force exists (see Exhibits 4-1 , 4-6 and 4-8).
Testifying before the Commission, Chairman Preston
Martin of the FHLBB stated, “even the federally
chartered institutions, over which we have the most
extensive control, are subject to state law in certain
respects,” but added that “compliance with state con-
sumer protection laws is not an area of primary interest
of our examiners” because of the minimal involvement
of savings and loan institutions in consumer loans. The
Commission understands that unsecured property im-
provements loans are only $667.4 million of a portfolio
of $147.3 billion, but believes that violations of con-
sumer laws could still affect substantial numbers of
citizens. Although aware that savings and loan associa-
tions seek much broader powers in the field of consumer
credit, the Commission has no evidence that broader
powers would be accompanied by assurances that
federally chartered associations would be examined for
compliance with state consumer protection laws. The
Commission questions how the FHLBB would ever
know state consumer credit protection laws have been
violated without efforts to ensure compliance. Viola-
tions of such laws might well have an adverse effect on
the solvency of the institutions— a subject of paramount
concern to the FHLBB. Additionally, if the FHLBB fails
to examine federally chartered associations for com-
pliance, no other agency has the power to make such
examinations.
The FHLBB, through the Federal Savings and Loan
Insurance Corporation, also insures the accounts of
many state chartered savings and loan associations, just
as the FDIC insures commercial banks’ deposits. As
insuror, the FHLBB has supervisory and examination
authority over insured state associations to protect its
insurance fund. Chairman Martin noted, however, that
FHLBB was “not heavily involved with the enforcement
of state consumer protection laws,” and that “in most
states . . . [the Board] conduct [s] ... examinations of
state chartered associations jointly with state supervisory
authorities . . . [who] are primarily chargeable with
matters of enforcement of state law.”
The Commission agrees that enforcement of state
consumer credit protection laws is primarily a state
responsibility, but this does not preclude FHLBB exam-
ination for compliance with such laws, particularly in
view of Chairman Martin’s statement that “[wjhile . . .
the states are primarily responsible for the enforcement
of their own consumer protection laws, violation of state
law by an insured institution, whether federally or state
chartered, could be the basis for cease and desist action
by our Board or, in an appropriate case, grounds for
termination of insurance of accounts.”
In view of the staffing, budgetary, and attitudinal
limitations of many state supervisory agencies, super-
vision of savings and loan associations, like that of
banks, probably is directed toward ensuring soundness
and leaves other matters unattended.
Credit Unions
At Commission hearings in June, 1971, J. Deane
Gannon, Deputy Administrator of the National Credit
Union Administration stated that “we (the National
Credit Union Administration) expect FCUs (Federal
Credit Unions) to comply with state laws,” but added
that “[a]s NCUA does not have enforcement respon-
sibilities for state consumer protection laws, it does not
build into its examinations specific procedures for
determining compliance.” He said that NUCA’s credit
manual advises credit unions to obtain an attorney’s
opinion that special loan programs do not violate laws in
the state where the Federal credit union does business.
Asked why the NCUA conducts no compliance exami-
nations, he said that the “vast majority of Federal credit
unions are members of state leagues” and ‘The leagues
see to it that member credit unions receive notice and
information on changes in state law or regulation.” He
added that “[m]any times the league has its attorney
review the law and determine its application to credit
unions.”
Mr. Gannon’s testimony left several questions un-
answered. If the NCUA does not examine for com-
pliance with state law, how does it know whether
Federal credit unions are complying with the law? It is
one thing to expect Federal credit unions to comply
with state law and another to examine to ensure
compliance. In view of its exclusive examination and
supervisory authority over Federal credit unions, who
can examine for and enforce compliance if the NCUA
does not? A supervisory agency like the NCUA should
not rely on credit union or league attorneys to deter-
mine what laws are applicable to institutions under its
48 C- 072 0 - 73 -6
55
jurisdiction, especially when an erroneous interpretation
might affect the soundness of the institution and
endanger depositors’ funds. It may also result in the
failure to extend protection of state laws to Federal
credit unions customers.
Although the NCUA was authorized by the Federal
Credit Union Act of 1 970 to examine and supervise
Federal and insured state chartered credit unions,
NCUA’s share insurance function has not yet been fully
implemented. 5 3 For this reason, the Commission cannot
now determine whether NCUA puts inordinate emphasis
on examining for soundness. It is apparent, however,
that some state examining agencies have neither suf-
ficient staff nor budget to examine adequately the
institutions under their supervision. Similarly, NCUA
appears to be seriously understaffed in some states
(Exhibit 4-7).
Consumer Finance Companies
Consumer finance companies are chartered only by
states and have no Federal counterparts. State agencies
charged with their supervision have complete respon-
sibility for their examination and for determining
whether the companies have complied with state con-
sumer loan laws. The Commission sifted through the
multiplicity of state laws and regulatory programs only
to find that vast dissimilarities made comparisons among
states almost impossible. The difficulty was heightened
by the divergent enforcement attitudes of the regulatory
agencies. Supervisory and enforcement activity ranged
from vigorous to languid— not only from state to state
but from agency to agency within states. This is partly
explained by the frequently expressed view that public
agencies wliich regulate private enterprises often begin to
empathize with the industries they are supposed to
supervise. 5 4
The Commission computed the number of man-days
per loan office each state consumer credit administrator
had available per year to examine consumer finance
companies. 5 5 For purposes of state comparisons, sam-
pling techniques minimize differences in loan office
sizes. Although it is impossible to demonstrate that any
state has sufficient manpower to examine its consumer
finance companies adequately, the Commission has no
evidence that every state fails to provide sufficient
resources for adequate examinations. The median figure
for the 33 states 54 included in the calculations was 2.64
man-days available per office, with a range from 1.15
days to 6.14 days. 57 Virtually all administrators con-
tacted by the Commission staff said that it took between
2 and 3 days to examine the average small loan office.
Assuming the quality of a 2 to 3 day examination is
sufficient to satisfy examination standards prescribed by
statute, approximately half of the states comply with
their mandates.
Administrators with less than 2.64 man-days available
per office tended to focus examination activities on new
licensees and licensees with a history of problems. While
recognizing that variations exist in the size of states and
the size of institutions examined, the Commission
recommends that legislatures and administrators in states
with less than 2-1 j2 man-days available per year per
small loan office reassess their staffing capabilities with
the goal of improving their ability to fulfill the examina-
tion responsibility prescribed by law.
Unfortunately, many consumer credit protections
presumed to exist at the state level are illusory. In many
states where such legal protections exist, the consumer
may not be truly protected in consumer credit transac-
tions because the laws are not evenly enforced.
Inconsistencies in administration and enforcement
should not be allowed to continue. All consumer credit
grantors should be subject to the same statutes and the
same administrative controls, although not necessarily
the same licensing, chartering, and examination proce-
dures. Enforcement of statutes should be performed
with consumer protection the primary concern— not
creditor convenience.
Truth in Lending (TIL)
Federal Agencies
At the Federal level, the Commission found examina-
tion and enforcement to be a “mixed bag.” Some
agencies have no specific budget for TIL activities.
Others have rather substantial budgets. Some agencies
have found so many violations that it is difficult to
understand how others have found so few. In some
agencies all examiners apparently devote a certain
percentage of their time to examining for TIL while in
others only a specific portion of the examining staff
devote time to TIL (see Exhibit 4-1 1). Two agencies
assigned TIL responsibilities -the Interstate Commerce
Commission and the Department of Agriculture-re-
ported they had encountered no consumer credit prob-
lems under TIL. This is understandable, since few, if
any, institutions subject to their jurisdiction extend
consumer credit as defined by TIL. A third agency, the
Civil Aeronautics Board, had virtually no enforcement
activity.
Of the remaining six agencies charged with TIL
enforcement, five— the Comptroller of the Currency, the
FDIC, the FRB, the FHLBB, and the NCUA-exercise
their authority to examine their respective supervised
institutions on a regular basis. Each has adopted as a part
of its examination process special procedures to test for
TIL compliance. However, the vigor with which each
56
agency pursues these procedures varies widely. Some
creditors are closely regulated and others are not. As with
state consumer credit protection laws, the effectiveness
of TIL protection varies with the Federal agency having
regulatory authority. Such variations are intolerable. The
Commission recommends that all Federal regulatory
agencies adopt and enforce uniform standards of Truth
in Lending examination.
The Federal Trade Commission (FTC) is unique as a
TIL enforcement agency in that (1) it has no general and
continuing supervisory and examination authority over
creditors under its TIL jurisdiction, and (2) as a practical
matter.it has no finite universe of creditors subject to its
jurisdiction. The other eight Federal agencies have TIL
enforcement authority over creditors which they regu-
larly supervise, so that the exercise of that authority is
(or should be) but one additional function applicable to
a known roster of regulatees. The universe of creditors
subject to FTC Truth in Lending jurisdiction far exceeds
that of any other agency both in number and institu-
tional diversity. Estimates of the number range as high as
one million and include retailers who extend consumer
credit, consumer finance companies, and state chartered
credit unions. Excluded, of course, are state chartered
and noncorporate creditors in the five states with TIL
exemptions.
To fulfill its TIL responsibilities, the FTC established
a Division of Consumer Credit (now a part of the
Division of Special Projects) with a staff of 204
members, whose sole function is to administer the CCPA
(including TIL). Because of the large number of cred-
itors for which the FTC is responsible and obvious staff
limitations, comprehensive examination for compliance
was not possible. Instead the agency relied on a program
of voluntary compliance and the deterrent effect of
numerous complaint cases initiated by the Division staff.
In an attempt to effectuate compliance, however, the
staff undertook examinations of disclosure statements of
national and major regional creditors and initiated an
extensive program of surveillance of advertising matter.
The FTC also made a nationwide survey of creditor
compliance to ascertain TIL trouble spots and focus on
the types of creditors under their jurisdiction who need
special surveillance. The Commission Commends the
FTC for efforts to fulfill a gargantuan assignment.
The Board of Governors of the Federal Reserve
System is also to be commended for admirably drafting
regulations and providing interpretations as prescribed
under section 105 of the Truth in Lending Act.
State Agencies
If the Federal examination and enforcement of TIL is
a “mixed bag,” the state situation may be no better. The
Commission recommends that all TIL exemptions be
reviewed by the FRB in light of testimony before the
Commission .
TIL regulatory functions currently exercised by the
FRB, as well as TIL examination and enforcement
functions which at present are assigned to nine different
Federal agencies and five exempted states should be
reassigned to the proposed Bureau of Consumer Credit.
The Commission finds it unrealistic to impose on any
agency a dichotomy of responsibility. If the agency’s
primary duty is to ensure the solvency and liquidity of
institutions under its jurisdiction, it is unrealistic to
expect that agency to enforce a law which provides for
potentially substantial civil penalties for its violation.
Agency assumption of an active consumer protection
role could have a detrimental effect on the very solvency
of an institution which the agency is required to protect.
THE PROBLEMS IN PERSPECTIVE
Problems in the field of enforcement of consumer
credit laws range from familiar, old problems that have
stubbornly resisted solution to emerging new areas of
concern. Among the old problems found still to exist are
these: (1) Federal agencies charged with supervising
deposit -holding institutions have evidenced great interest
in the solvency of the institutions, much less interest in
enforcing Federal consumer credit laws, and virtually no
interest in enforcing state consumer credit laws. Because
state agencies are generally barred from examining
federally chartered institutions, those institutions are
not effectively examined for violations of state con-
sumer credit laws. (2) State agencies charged with
examining deposit-holding institutions are preoccupied
largely with the solvency of the institutions even though
their examinations often duplicate those of Federal
authorities. This duplication of effort drains away
resources that might otherwise be used for enforcement
of consumer credit laws. (3) States have usually failed to
set up effective mechanisms for across-the-board en-
forcement of consumer credit laws. Although state laws
usually give administrators adequate powers to enforce
credit laws against consumer finance companies, compet-
ing second mortgage lenders are generally subject to
little or no administrative supervision. Similarly, in most
states retailers are subject to no administrative super-
vision for credit law purposes. Recourse against retailers
for violations of credit laws is usually limited to suit by
aggrieved consumers or to criminal or injunctive proce-
dures instituted by state attorneys general or local
district attorneys. (4) State legislatures in the last two
decades have enacted countless consumer protection
statutes but have been reluctant to appropriate funds to
enlarge consumer protection agencies in order to enforce
57
these laws. State agencies usually have adequate financ-
ing only when creditors pay for examinations, as with
agencies examining deposit-holding institutions or con-
sumer finance companies. 5 8
Among the new problems are these: (1) Increased
intervention by the Federal Government in the
consumer protection area has raised difficult problems
of Federal-state relations which call for reconsideration
of the roles played by state and Federal authorities in
enforcing consumer protection laws.
States not exempt from Federal TIL supervision may
have two laws on disclosure of finance charges, the
Federal TIL provisions and state laws which predate the
Federal law and which have not been expressly repealed.
Although TIL Section 111(a) purports to invalidate
inconsistent state laws on disclosure, the FRB in
regulation Z Section 226.6(c) allows creditors to con-
tinue to make disclosures pursuant to inconsistent state
laws so long as they are separated from Federal
disclosures and branded as being inconsistent with
Federal law. Incredible as it may seem, if state law
differs from the Federal law a creditor would apparently
be required to disclose different APR’s, one under
Federal law and one under state law so long as the
separation requirements of the regulation were observed.
In those nonexempted states there are two separate
groups of enforcement officials- -Federal agencies enforc-
ing TIL and state agencies enforcing state consumer
credit law-and, in most cases, both groups are enforcing
different laws against the same creditors. Since only
Federal authorities can enforce TIL, in nonexempt
states the FTC has the burden of covering all state
chartered credit unions, all retailers, consumer finance
companies and second mortgage lenders with no help
from state officials.
Nor is all well in the exempt states. Before exemp-
tions are granted, state legislatures must enact a statute
“substantially similar” to the Federal Truth in Lending
Act (the FRB has interpreted this to mean “substantially
identical”) and rules must be adopted which incorporate
the substantive provisions of regulation Z. Each time
Congress amends TIL and each time the FRB amends
regulation Z (which has happened a number of times),
similar changes must be made in state statutes and rules;
failure to make changes promptly may result in loss of
the state’s exemption. To obtain and maintain exemp-
tions, states find themselves merely rubber-stamping
Federal legislative and administrative provisions. Thus,
the only effect of exemption is to permit state au-
thorities exclusive enforcement powers with respect to
TIL (except as to federally chartered institutions) and,
of course, to deprive the FTC of such authority. After
expending the effort necessary to obtain exemption
from TIL, the money-starved states find that all they
have achieved are greatly increased burdens (but prob-
ably not budgets) for their consumer protection agencies
and the loss of FTC assistance. It is no wonder that
exemptions have not been as eagerly sought as some
thought they would be when TIL was enacted.
(2) Rising expectations of consumers concerning
protection of their rights in credit transactions have
focused attention on better ways of helping the con-
sumer protect himself. No longer is it enough to have
remote governmental authorities police creditors with
the expectation that violations can be prevented or, once
found, halted. Consumers want direct access to agencies
capable of telling them of their rights and of assisting
them in remedying wrongs done to them. They want
educational programs to help them avoid trouble in
consumer transactions. They want skilled legal services
to press their claims. In short, aggrieved consumers yearn
for a concerned and informed human being to hear their
complaints and tell them what to do. The quality of
enforcement of consumer credit laws must now be
evaluated on the basis of availability to the public of
educational programs, counseling facilities, and compe-
tent legal services, as well as by the old quantitative
standards in terms of numbers of creditor examination
agents.
Federal Watchdog Agency
The Commission’s review of supervision and examina-
tion of credit grantors by state and Federal agencies
charged with those responsibilities has uncovered certain
weaknesses in the enforcement of state and Federal
consumer credit protection laws. To strengthen protec-
tion of the consumer in the credit market the Commis-
sion feels that an organizational unit is needed at the
Federal level to coordinate activities of supervisory
agencies, improve compliance with existing Federal and
state consumer credit protection laws, implement cer-
tain of the Commission’s recommendations and continue
certain of the basic consumer credit market research
initiated by the Commission. Therefore the Commission
recommends that Congress create within the proposed
Consumer Protection Agency a unit to be known as the
Bureau of Consumer Credit (BCC) with full statutory
authority to issue rules and regulations and supervise all
examination and enforcement functions under the Con-
sumer, Credit Protection Act, including TIL. The BCC
would also encourage state consumer credit administra-
tors and banking departments to augment existing staff,
where necessary, and improve existing examination and
enforcement procedures. For these purposes, the BCC
should be empowered to make independent determina-
tion of the adequacy of state supervision, examination,
58
and enforcement of applicable state and Federal con-
sumer credit protection laws and recommend to Con-
gress steps the BCC deems necessary to ensure protec-
tion of the consuming public in credit transactions.
If Congress should not enact the proposed Consumer
Protection Agency, the Commission recommends-as an
alternative to the BCC-creation of an independent
Consumer Credit Agency to implement some Commis-
sion recommendations.
The following specific recommendations relate to
creation of the Bureau:
- The BCC should monitor progress in the development
of competitive consumer credit markets (Chapter 7) as
well as in the elimination of discriminatory practices in
granting consumer credit (Chapter 8). It should also
undertake research to develop viable credit scoring
systems to facilitate credit granting in poverty areas
(Chapters 8 and 9).
The BCC should be empowered to cooperate with
and offer technical assistance to states in matters relating
to consumer credit protection— examinations, enforce-
ment, and supervision of consumer credit protection
laws.
To fulfill the BCC’s responsibilities as a CCPA
rulemaking body and to permit it to evaluate and
monitor state activities in areas of consumer credit
protection and in development of competitive consumer
credit markets, the BCC should be authorized:
(1) to require state and Federal agencies that super-
vise institutions which grant consumer credit to
submit such written reports;
(2) to administer oaths;
(3) to require by subpoena the attendance and
testimony of witnesses and the production of all
documentary evidence relevant to the execution
of its duties;
(4) to intervene in corporate mergers and acquisi-
tions which might lessen competition in con-
sumer credit markets. The authority to intervene
should include but not be limited to applications
for new charters, offices, branches, etc.;
(5) in the case of disobedience to a subpoena or
order issued, to invoke the aid of any district
court of the United States in requiring com-
pliance with such subpoena or order; and,
(6) in any proceeding or investigation, to order
testimony to be taken by deposition before any
person designated by the Bureau who has the
power to administer oaths, and in such instances
to compel testimony and the production of
evidence in the same manner as authorized under
subparagraphs (3) and (5) above.
If barriers to competition in the consumer credit
market are not eliminated, federally chartered finance
companies should be established utilizing the BCC as the
chartering and supervisory agency (Chapter 9).
The Commission believes the activities of the BCC
will help to create an environment of consumer credit
pro tecti on heretofore unattaine d .
SUMMARY
Of the broad recommendations which can be made
on enforcement of consumer credit protection laws,
some are intended to advance healthy trends which have
been developing while a few call for departure from
existing procedures.
Deposit Holding Institutions
Agencies regulating deposit-holding institutions have
long been devoted to the traditional role of examining to
prevent institutional failure. It is no surprise, then, that
these agencies have not eagerly enforced consumer credit
protection laws against the institutions they regulate.
Vigorous enforcement of such laws would not be
welcomed by agencies with limited personnel resources
and heavy responsibility for maintaining the safety of
depositor funds. Perhaps more important are attitudinal
obstacles. These agencies are accustomed to insuring
institutional soundness and protecting depositors, and
the assumption of responsibility for enforcing laws
protecting debtors would require a significant change in
attitude. However, the growing threat of class action
suits by aggrieved debtors and the potential for large
amounts in damages should alert institutions and super-
visory agencies to the benefits of preventive examination
for compliance with consumer credit protection laws.
Two persistent criticisms about regulation of deposit-
holding institutions are: first, federally chartered institu-
tions not only have failed to enforce consumer protec-
tion laws but have refused visitation rights to state
authorities to allow for enforcement. Second, limited
resources of state examination agencies are wasted on
bank examinations which largely duplicate the work of
Federal examiners, particularly in the case of FRB state
member banks and nonmember banks insured by the
FDIC.
The Commission recommends that agencies supervise
ing federally chartered institutions undertake systematic
enforcement of Federal credit protection laws like Truth
in Lending.
Checking for violations can be a routine part of every
examination without unduly burdening examiners. Testi-
mony from a Commission hearing indicates that agencies
are moving in that direction. The trend should be
encouraged. National banks hold billions of dollars
59
worth of notes and assigned contracts that may not be
adequately examined by Federal authorities and cannot
be examined by authorities of the states whose laws
govern these contracts. The Commission recommends
that Federal law be expressly changed to authorize state
officials to examine federally chartered institutions for
the limited purpose of enforcing state consumer laws,
but such authorization should in no way empower state
officials to examine federally chartered institutions for
soundness, fraudulent practices, or the like. The limited
state examination should be required by law to be
performed in a manner that would not disrupt or harass
the federally chartered institutions. State examiners
could accompany Federal examiners as additional mem-
bers of the examination team. Institutions could com-
pensate the state for its examiners’ services at rates equal
to those paid for Federal examiners.
Although the banking industry favors elimination of
dual examination by Federal and state agencies, all but a
few state banks undergo dual examination for sound-
ness, fraud, and management evaluation. The Commis-
sion believes that tills is a wasteful duplication and that
to the extent possible state and federal agencies should
work together to assure that examination for soundness
be primarily a Federal responsibility. This would be
desirable from a consumer standpoint because it would
leave more resources available to state authorities to
devote to enforcing state and Federal consumer credit
laws in state banks. 5 9
Nondeposit Holding Lenders
Two developments are needed for nondeposit holding
lenders to provide adequate consumer protection.
(1) Licensed lenders are usually well supervised by
state agencies for compliance with state consumer laws,
but other consumer lenders are not. The Commission
recommends that state consumer credit laws be amended
to bring second mortgage lenders and any other con-
sumer lenders under the same degree of administrative
control imposed on licensed lenders. This can be done
by (a) defining a consumer loan as one with an APR high
enough to exclude residential purchase money first
mortgage credit-say 12 percent -made for personal,
family, or household purposes; (b) requiring all credit
related charges such as brokerage fees, points, and
commissions to be included in the finance charge; and
(c) requiring any creditor to obtain a license before
making a consumer loan.
(2) A basic change in Federal-state relations with
respect to Federal consumer credit laws must be made.
The Federal Government may well become a more
important source of legislation applicable to consumer
transactions. Congress presented states with two some-
what unsatisfactory alternatives in TIL enforcement: A
state may obtain an exemption and then enforce TIL
against all creditors (except federally chartered institu-
tions) with no Federal financial assistance, or it may
leave enforcement to the FTC and other Federal
enforcement agencies. Most states have chosen the latter.
If the Federal Government and the states are to coexist
in consumer credit legislation and enforcement activities,
an effective working relationship must replace the
all-or-nothing exemption option.
The Commission recommends that Congress consider
whether to empower state officials to enforce Truth in
Lending and garnishment restrictions of the Consumer
Credit Protection Act and any similar laws that may be
enacted. Concurrent jurisdiction over TIL is expressly
given to state courts. Why not concurrent enforcement
powers for state officials? The benefits are obvious in
the licensed lender field whose operations are examined
in minute detail in many states. The skilled state
examiner could also look for TIL violations and ease the
already heavy FTC workload. The FTC has agreements
with some state agencies which provide for state
examination and reporting of TIL violations to the FTC.
Federal legislation might go further and allow a state
agency to treat a TIL violation as a violation of state law
subject to remedies (cease and desist powers, etc.)
available under state law. Duplication of efforts by
Federal and state authorities could be eliminated and
expenses of enforcement shared.
Retailers and Their Assignees
The Commission recommends that state laws covering
retailers and their assignees be amended, where neces-
sary, to give authority to a state administrative agency to
enforce consumer credit laws against all sellers who
extend consumer credit. However, administrative regula-
tion need not and should not entail either licensing or
limitations on market access.
Only a few states exercise this authority over sellers,
but buyers are as entitled to protection and enforcement
as borrowers. x
Regulation of retailers must, of course, be extended
to assignees of consumer credit paper. All banks and, in
many states, sales finance companies are subject to
administrative control. The Commission recommends
that states which do not subject sales finance companies
to enforcement of consumer credit laws amend their
laws to bring such companies under enforcement. Such
authority need not and should not entail licensing or
limitations on market access.
The degree of administrative control must be deter-
mined by the availability of resources. The sheer number
of retail outlets would appear to make detailed periodic
examination and voluminous reports similar to those
60
required of deposit-holding institutions and consumer
finance companies unrealistic. The almost unanimous
conclusion of state administrators testifying before the
Commission was that reliance on consumer complaints is
an inadequate basis for consumer protection. To some
degree administrators must take the initiative and seek
out violations by examining retail creditors.
New developments in retail credit operations should
make enforcement easier. Many retailers now participate
in credit card plans in which the issuer extends and holds
the credit and the retailers either reduce or abandon
their own credit plans. Administrative control over a few
credit card issuers may accomplish what previously
would have taken an army of examiners to do. Also, use
of centralized electronic data processing by retail credi-
tors with multiple branches eases the examiners’ tasks.
Many large item credit sales-automobiles, furniture,
and appliances— are still made by closed end instalment
contracts assigned to banks or sales finance companies.
Laws which abolish the holder in due course doctrine
and subject assignees to liability for knowingly violating
credit laws are powerful factors in enlisting natural
market forces to enforce credit laws (see Chapter 10).
Assignees generally will not buy trouble, avoiding those
dealers known to write contracts which violate laws.
TIL enforcement is most needed in the retail field
where reprehensible credit sellers prey on the poor and
ignorant. Administrative agencies need all the weapons
they can muster against these abusers and often a TIL
violation is the easiest charge to prove.
Better Enforcement at All Levels
Consumer credit laws come from the Congress, state
legislatures, and local governments. Each has enforce-
ment units that should help make the laws effective. At
the Federal level the FTC is adding valuable experience
to its commendable enthusiasm in enforcing Federal
consumer protection laws. Because the FTC is free of
any continuing relationship with any class of credit
supplier, it possesses singular objectivity. Congressional
commitment to consumer protection may well be
gauged by the degree to which FTC appropriations
match the additional workload caused by new consumer
protection laws. Federal agencies which charter or insure
financial institutions may lack the verve of independent
agencies in enforcing credit laws, but they can observe
operations of institutions under their supervision and
can perform a valuable service by examining for credit
violations.
Consumers are entitled to much better consumer
credit protection law enforcement at the state level than
they have been receiving. Inconsistencies that have left
some lenders heavily regulated, others virtually unregu-
lated, and sellers regulated in only few states can no
longer be tolerated. The Commission recommends that
state laws be amended to give a state administrative
agency authority to enforce consumer credit laws against
all credit grantors-deposit holding institutions, non-
deposit holding lenders, and retailers and their assignees.
This authority should include the right to enter places of
business, to examine books and records, to subpoena
witnesses and records, to issue cease and desist orders to
halt violations, and to enjoin unconscionable conduct in
making or enforcing unconscionable contracts. The
agency should be able to enforce the rights of con-
sumers, as individuals or groups, to refunds or credits
owing to them under appropriate statutes. Across-the-
board administrative control over all creditors is essential
for an adequate level of state enforcement. Most states
now have separate administrative agencies, usually the
chartering or licensing agency, charged with supervising
banks, savings and loan associations, and consumer
finance companies. Another agency to oversee non-
licensed creditors such as retailers must be created unless
such enforcement is assigned to an existing agency.
The proliferation of agencies at the state level seems
to be wasteful of limited enforcement resources. Placing
authority to enforce all consumer laws against all credit
suppliers under a single administrator and establishing
separate subdepartments to license and supervise dif-
ferent types of creditors seems an ideal structure. If
political or other considerations make such centraliza-
tion infeasible, a consumer protection board composed
of heads of consumer-related agencies should be estab-
lished which should meet regularly to coordinate en-
forcement activities.
It is at the local level that some of the most
innovative and useful enforcement activity occurs, pos-
sibly because local agencies supervise no financial insti-
tutions. The New York City Bureau of Consumer Affairs
has been as creative in finding new ways to protect
consumers as it has been tenacious in enforcing laws.
Other cities, Los Angeles among them, are patterning
programs on the New York experience. Federal and state
agencies have felled to develop communication inter-
change necessary for a truly effective consumer protec-
tion program. It may be that communication between
consumers and governmental regulators can be most
effective at the local level. The local representative can
more effectively halt the put-offs and run arounds,
obtain quicker action, and provide on the spot advice.
The local ombudsman can use persuasion and publicity
as primary tools, but the legal authority needed cannot
be assessed until the office is funded, staffed, and
operating.
61
Legal Services
Consumer credit transactions normally involve such
comparatively small sums that it is often difficult to
interest lawyers in litigation involving them. However,
litigation brought by aggrieved private consumers may
prove a powerful deterrent to institutional misconduct.
Low income consumers have found advocates of their
rights in legal services programs. Therefore, the Commis-
sion recommends that legal services programs- legal aid,
neighborhood legal services, rural legal assistance, public
defender-continue to receive Federal, state, and local
government support.
Litigation by the private consumer would be en-
couraged if statutes assure payment of fees to the
consumer’s lawyer in cases in which he prevails. Such
fees should be based on the reasonable value of the
service, not on the amount of recovery. The Commission
recommends that consumer protection laws be amended,
where necessary, to assure payment of legal fees incurred
by aggrieved private consumers and provide them with
remedies they can enforce against creditors who violate
these laws.
Watchdog Agency
The Commission recommended a Bureau of Con-
sumer Credit in the Consumer Protection Agency if
established by Congress. Failing that, the Commission
recommended creation of a Consumer Credit Agency to
implement some of its recommendations.
62
EXHIBIT 4-1
STATUS OF STATE BANK SUPERVISION
Major Regulatory Responsibilities in Addition to Commercial Batiks^ 1 *
Savings and
Mutual Savings Loan Industrial Loan Money Order
State Banks Credit Unions Associations Companies Companies
Alabama x x
Alaska x
Arizona x x
Arkansas x
California
Colorado ........ x x
Connecticut x x x
Delaware x x
Florida x x
Georgia x
Hawaii x x
Idaho x x
Illinois
Indiana x x
Iowa x
Kansas
Kentucky x x x
Louisiana x x
Maine x x x x
Maryland x x x
Massachusetts .... x x x
Michigan x x
Minnesota x x x x
Mississippi x x
Missouri x
Montana x x
Nebraska x x x
Nevada
New Hampshire ... x x
New Jersey x x x
New Mexico ..... x x
New York x x x x
North Carolina . . .
North Dakota .... x x
Ohio
x
x
X
X
X
X
X
X
X
X
X
Finance
Companies
x
x
x
x
x
x
x
x
X
X
X
X
X
X
X
X
X
X
X
X
X
X
X
X
X
X
63
EXHIBIT 4-1 (Cont'd)
STATUS OF STATE BANK SUPERVISION
Major Regulatory Responsibilities in Addition to Commercial Banks* 1 )
Savings and
Mutual Savings Loan Industrial Loan Money Order Finance
State Banks Credit Unions Associations Companies Companies Companies
Oklahoma x x x
Oregon x x x x x
Pennsylvania x x x x x
Puerto Rico x x x
Rhode Island x x x x
South Carolina ... . x x
South Dakota x x
Tennessee x
Texas x
Utah x x x x
Vermont x x x
Virginia x x x x
Washington x x x
West Virginia ..... x x x x
Wisconsin x x x
Wyoming x x
TOTALS 16 33 28 17 17 37
(1) The types of non-bank financial institutions under the jurisdiction of the state banking department vary considerably from state
to state; in addition to the responsibilities listed here, some departments supervise such activities as investment companies, insurance
firms, employee welfare funds, money remitters, development corporations, mortgage companies and perpetual care cemeteries.
Source; 1971 Survey of State Bank Supervisors
EXHIBIT 4-2
Staffing of State Attorneys General's Consumer Protection Agencies
(as of February 1971)
State
Attorneys
Investigators
Clerical
Student Aides
Alabama .
1
PT
Alaska
0
0
0
0
Arizona
1
FT
1
FT
1
PT
Arkansas
2
PT
California
6
FT, 4
PT
4
FT
4 FT, 4 PT
Colorado
1
FT
1
FT
1
FT
1
FT
.Georgia
1
PT
Hawaii
3
FT
5
FT
4
FT
2
FT
Illinois
14
FT, 3
PT
7
FT
14
FT
Indiana
1
PT
Iowa
2
FT
2
PT
2
FT
1
PT
Kansas
1
PT
1
FT
, 3
PT
1
PT
Kentucky
1
FT
1
FT
1
FT
Maine
1
PT
2
PT
Maryland
2
FT
3
FT
, 1
PT
3
FT
8
FT
Massachusetts
4
FT
9
FT
4
FT
5
FT
Michigan
2
FT
1
FT
3
FT
Minnesota
1
FT
1
PT
Missouri
1
FT, 1
PT
2
FT
, 1
PT
3 FT, 1 PT
1
PT
Nebraska
1
PT
New Jersey
2
FT
15
FT
13
FT
3
PT
New Mexico
2
PT
2
PT
1
PT
New York
12
FT
3
FT
4
FT
North Carolina
6
FT
4
FT
10
FT
North Dakota
1
PT
Ohio
1
FT
5
FT
2
FT
Oklahoma
2
PT
Oregon
1
PT
Pennsylvania
3
FT
11
FT
6
FT
Puerto Rico
7
FT
75
FT
68
FT
(116-
-Other)
South Dakota
1
PT
1
PT
Texas
5
FT
1
FT
Virgin Islands
8
PT
Washington
6
FT, 2
PT
5
FT,
, 1
PT
3 FT
’, 9 PT
West Virginia
1
PT
1
PT
Wisconsin . . , ,
1
FT, 1
PT
1
FT
3
FT
4
FT
FT: Full Time
PT: Part Time
/
Source: Report on The Office of the Attorney General, National Association of Attorneys General, Committee on the Office of the
Attorney General, February 1971.
65
EXHIBIT 4-3
Examination Staff of the Office of the Comptroller of the Currency
(as of January 1972/
Region
State
Banks
Branches
Examiners
1
Connecticut
26
249
8
Maine .
19
109
6
Massachusetts
82
441
49
New Hampshire
48
54
10
Rhode Island
5
95
9
Vermont
26
49
4
2
New Jersey
120
753
113
New York
167
1,338
116
3
Delaware
5
4
0
Pennsylvania
286
1,088
107
4
Indiana
122
362
24
Kentucky
80
151
12
Ohio
218
776
54
5
District of Columbia
14
106
19
Maryland
39
270
6
North Carolina
23
615
8
Virginia
101
511
41
West Virginia. . .'
87
0
14
6
Florida
230
0
56
Georgia
62
216
17
South Carolina
19
230
10
7
Illinois
415
71
95
Michigan
104
581
25
8
Alabama
88
209
28
Arkansas
69
88
11
Louisiana .
49
185
15
Mississippi
38
145
9
Tennessee
77
290
33
9
Minnesota
198
7
60
North Dakota
42
10
9
South Dakota
32
63
11
Wisconsin
126
68
24
10
Iowa
100
60
18
Kansas
171
35
16
Missouri
98
26
36
Nebraska
125
26
18
66
EXHIBIT 4-3 (Cant'd)
Examination Staff of the Office of the Comptroller of the Currency
(as of January 1972)
Region
State
Banks
Branches
Examiners
11
Oklahoma
195
32
32
Texas
532
0
125
12
Arizona
3
226
7
Colorado
121
13
38
New Mexico
33
79
9
Utah
8
75
9
Wyoming
42
0
8
13
Alaska
5
52
0
Idaho
7
114
6
Montana
52
1
12
Oregon
8
257
18
Washington
24
463
27
14
California
57
2,473
118
Hawaii
1
9
0
Nevada
4
64
2
Totals
4,603
13,139
1,502
Source: Office of the Comptroller of the Currency.
67
EXHIBIT 4-4
Examination Staff of the Federal Deposit Insurance Corporation
(as of June 30, 1971}
Region and State
Number of
Banks
Number of
Branches
Number of
Examiners
Atlanta
821
240
129
Alabama
Florida
Georgia
Boston
300
839
98
Connecticut
Maine
Massachusetts
New Hampshire
Rhode Island
Vermont
Chicago 865 295 157
Illinois
Indiana
Columbus 499 373 91
Kentucky
Ohio
West Virginia
Dallas 980 137 115
Colorado
New Mexico
Oklahoma
Texas
Madison 569 422 90
Michigan
Wisconsin
Memphis 698 670 114
Arkansas
Louisiana
Mississippi
Tennessee
Minneapolis 795 102 94
Minnesota
Montana
North Dakota
South Dakota
Wyoming
New York 255 900 174
New Jersey
New York
Puerto Rico
Virgin Islands
68
EXHIBIT 4-4 (Cont'd)
Examination Staff of the Federal Deposit Insurance Corporation
(as of June 30, 1971)
Region and State
Number of
Banks
Number of
Branches
Number of
Examiners
Omaha
Iowa
Nebraska
814
256
103
Philadelphia
Delaware
Pennsylvania.
160
646
93
Richmond
313
1,271
94
Dist. of Col.
Maryland
North Carolina
South Carolina
Virginia
St. Louis 902 89 110
Kansas
Missouri
San Francisco 256 922 119
Alaska
Arizona
California
Guam
Hawaii
Idaho
Nevada
Oregon
Utah
Washington
Totals 8,227 7,162 1,581
Source: Federal Deposit Insurance Corporation.
69
EXHIBIT 4-5
Examination Staff of the Federal Reserve System
(as of June 30, 1971)
District and State
Number of
Number of Banks Number of Branches Examiners
Boston 25 333 43
Connecticut
Maine
Massachusetts
New Hampshire
New York 97 1,180 118
Connecticut
New Jersey
New York
Philadelphia 25 243 34
Delaware
New Jersey
Pennsylvania
Cleveland 138 485 38
Kentucky
Ohio
Pennsylvania
West Virginia
Richmond 91 235 42
Dist. of Col.
Maryland
North Carolina
South Carolina
Virginia
West Virginia
Atlanta 63 130 36
Alabama
Florida
Georgia
Louisiana
Mississippi
Tennessee
Chicago 285 499 66
Illinois
Indiana
Iowa
Michigan
Wisconsin
70 '
EXHIBIT 4-5 {Corn'd!
Examination Staff of the Federal Reserve System
(as of June 30, 1971)
District and State
Number of
Number of Banks Number of Branches Examiners
St. Louis 110 90 32
Arkansas
Illinois
Indiana
Kentucky
Mississippi
Missouri
Tennessee
Minneapolis 110 47 19
Michigan
Minnesota
Montana
North Dakota
South Dakota
Wisconsin
Kansas City 102 17 19
Colorado
Kansas
Missouri
Nebraska
New Mexico
Oklahoma
Wyoming
Dallas 62 41 24
Arizona
Louisiana
New Mexico
Oklahoma
Texas
San Francisco 30 412 49
California
Idaho
Nevada
Utah
Washington •
Totals 1,138 3,712 520
Source: Federal Reserve System
486-072 0 - 73 -7
71
EXHIBIT 4-6
Examination Staff of the Federal Home Loan Bank Board
(as of January 1972)
FHLBB District and State
Federally Chartered
Institutions - Branches
State Insured
Institutions - Branches
Number of
Examiners
Per District
No. 1 - Boston
69
86
80
27
21
Connecticut
18
43
17
10
Maine
9
5
15
2
Massachusetts
31
34
26
1
New Hampshire
7
0
12
0
Rhode Island
2
3
5
14
Vermont
2
1
5
0
No. 2 - New York
119
223
276
275
52
New Jersey
24
43
184
200
New York
86
158
92
75
Puerto Rico
9
20
0
0
Virgin Islands
0
2
0
0
No. 3 - Pittsburgh
149
144
188
126
46
Delaware
2
1
2
1
Pennsylvania
124
143
179
125
West Virginia
23
0
7
0
No. 4 - Greensboro
466
575
232
229
75
Alabama
52
44
7
13
Di st. of Col
11
22
9
19
Florida
128
204
5
2
Georgia
98
98
4
0
Maryland
59
62
22
32
North Carolina
39
47
129
80
South Carolina
47
39
23
22
Virginia
32
59
33
61
No. 5 - Cincinnati
298
257
205
200
63
Kentucky
91
33
12
2
Ohio
137
179
193
198
Tennessee
70
45
0
0
No. 6 - Indianapolis
139
205
93
94
29
Indiana
103
67
66
15
Michigan
36
138
27
79
No. 7 - Chicago
189
23
396
48
63
Illinois
149
2
310
0
Wisconsin
40
21
86
48
No. 8 - Des Moines
157
134
136
98
28
Iowa
45
17
36
14
Minnesota
52
61
11
2
Missouri
44
51
78
69
North Dakota
7
5
4
13
South Dakota
9
0
7
0
72
EXHIBIT 4-6 (Cont'd)
Examinal
State
edit Union t
Examination Staff of the Federal Home Loan Bank Board
(as of January 1972)
Number of
Federally Chartered State Insured Examiners
FHLBB District and State Institutions - Branches Institutions - Branches Per District
No. 9 - Little Rock 200 80 309 285 63
Arkansas 40 12 22 6
Louisiana 4 36 10 68 44
Mississippi 35 12 5 3
New Mexico 10 8 21 11
Texas 79 38 193 221
No. 10 -Topeka 102 76 130 141 31
Colorado 20 24 31 72
Kansas 29 15 59 44
Nebraska 23 13 18 16
Oklahoma 30 24 22 9
No. 1 1 - Los Angeles 72 267 147 538 86
Arizona 3 26 10 45
California 68 238 132 476
Nevada 1 3 5 17
No. 12- Seattle 89 159 62 159 33
Alaska 3 5 0 0
Hawaii . . . 2 5 8 52
Idaho 8 12 3 7
Montana 11 7 1 0
Oregon 18 41 12 47
Utah 6 6 7 12
Washington 32 82 27 37
Wyoming 9 1 3 3
Guam 0 0 1 1
Totals 2,049 2,229 2,256 2,220 590
Source: Federal Home Loan Bank Board.
73
EXHIBIT 4-7
Examination Staff of the National Credit Union Administration
(as of December 1971)
State Credit Unions Examiners
Alabama 236 5
Alaska * - 38 1
Arizona 118 3
Arkansas 92 1
California 1,238 38
Colorado . 172 4
Connecticut 307 1 1
Delaware 82 2
District of Columbia 187 11
Florida 339 7
Georgia 276 6
Hawaii 169 5
Idaho 66 1
Illinois 419 13
Indiana 487 6
Iowa 14
Kansas 73 1
Kentucky 125 2
Louisiana 373 9
Maine 164 5
Maryland 204 2
Massachusetts 360 9
Michigan 394 10
Minnesota 65 1
Mississippi. 155 3
Missouri 44 1
Montana 122 2
Nebraska 96 2
Nevada 66 1
New Hampshire 33 1
New Jersey 540 12
New Mexico 67 1
New York 1,082 26
North Carolina Ill 1
North Dakota 33 1
Ohio 719 19
Oklahoma 138 3
Oregon 230 6
Pennsylvania 1,304 33
Rhode Island 31 1
South Carolina 137 3
South Dakota 114 2
Tennessee 209 9
Texas 938 22
Utah 98 3
Vermont 3
74
EXHIBIT 4-7 (Cont'd)
Examination Staff of the National Credit Union Administration
(as of December 1971)
State . Credit Unions Examiners
Virginia
Washington .
West Virginia
Wisconsin . . .
Wyoming . . .
248
210
169
6
55
4
5
3
Totals
12,956
317
Source: National Credit Union Administration
75
EXHIBIT 4-8
Examination Staffs of State Banking Departments
(as of June 1971)
State
Banks and T otal Banks
Trust Companies Branches and Branches
Alabama
184
81
265
Alaska
6
7
13
Arizona
10
113
123
Arkansas
184
84
268
California
93
651
744
Colorado
154
7
161
Connecticut
34
209
243
Delaware
13
89
102
District of Columbia
3
36
39
Florida
300
28
328
Georgia
374
154
528
Hawaii
9
132
141
Idaho
17
48
65
Illinois
709
42
751
Indiana
285
299
584
Iowa
567
265
832
Kansas
430
35
465
Kentucky
263
194
457
Louisiana
183
220
403
Maine
24
126
150
Maryland
73
378
451
Massachusetts
75
331
406
Michigan
229
656
885
Minnesota
533
7
540
Mississippi
145
212
357
Missouri
575
70
645
Montana
93
5
98
Nebraska
315
18
333
Nevada
4
26
30
New Hampshire
26
12
38
New Jersey
90
345
435
New Mexico
34
59
93
New York
145
1,090
1,235
North Carolina
73
591
664
North Dakota
127
59
186
Ohio
297
577
874
Oklahoma
237
22
259
Oregon
38
95
133
Pennsylvania
167
695
862
Rhode Island
8
80
88
South Carolina
81
188
269
South Dakota
128
40
168
Tennessee
232
222
454
Texas . . . .
678
62
740
Utah
40
64
104
Vermont
17
38
55
Virginia
136
350
486
See footnotes at end of table.
Number of
Examiners
r
14*
15+
54
18
41°
3*
42°
38
18*
98
26
44
23
22
19
14 y
21
57
48
42
15
62
10 v
22
5
16 y
45 z
14
317*
16
42
19
10
69
12
8
25
85
3
6 *
76
EXHIBIT 4-8 (Cont'd)
Examination Staffs of State Banking Departments
(as of June 1971)
Banks and Total Banks Number of
State Trust Companies Branches and Branches Examiners
Washington 64 121 185 16
West Virginia 115 6 121 '12*
Wisconsin 483 212 695 48
Wyoming 29 1 30 6
Totals 1,541
* Responsible for examining all financial institutions.
+ Responsible for examining all financial institutions except credit unions and savings and loans.
0 Responsible for examining savings and loans as well.
y Responsible for examining all financial Institutions except consumer finance and related institutions.
2 Responsible for examining commercial and savings banks.
Source: Conference of State Bank Supervisors
77
EXHIBIT 4-9
STATE CHARTERED INSTITUTIONS
Consumer Finance Companies with Designated Examiners
{as of November 1971 )
State
Number of
Number of Offices Examiners
Man-Days Man-Days Available
Available Per Office
Alabama
Alaska
Arizona
Arkansas
396
5
1,200
3.03
California
1,995
51
12,240
6.14
Colorado
750
4
960
1.28
Connecticut
Delaware
Dist. of Col
417
10
2,400
5.75
Florida
914
10
2,400
2.63
Georgia
Hawaii
Idaho
1,112
12
2,880
2.59
Illinois
800
12
2,880
3.6
Indiana
781
16
3,840
4.92
Iowa
354
4
960
2.71
Kansas
329
7
1,680
5.11
Kentucky
451
5
1,200
3.66
Louisiana
Maine
941
5
1,200
1.28
Maryland
Massachusetts
340
6
1,440
4.24
Michigan
Minnesota
600
8
1,920
3.20
Mississippi
425
8
1,920
4.52
Missouri
580
3
720
1.24
Montana
65
1
240
3.70
Nebraska
Nevada
208
1
240
1.15
New Hampshire
88
1
240
2.73
New Jersey
499
5
1,200
2.40
New Mexico
New York
201
1
240
1.19
North Carolina
North Dakota
566
5
1,200
2.12
Ohio
1,556
11
2,640
1.70
Oklahoma
508
4
960
1.89
Oregon
Pennsylvania
Rhode Island
233
7
480
2.06
South Carolina
682
6
1,440
2.1k
South Dakota
72
1
240
3.33
Tennessee
455
5
1,200
2.64
78
EXHIBIT 4 : 9(Cont'd)
STATE CHARTERED INSTITUTIONS
Consumer Finance Companies with Designated Examiners
(as of November 1971)
Number of Man-Days Man- Days Available
State Number of Offices Examiners Available Per Office
Texas 2,265 16 3,840 1.70
Utah
Vermont 380 2 480 1.26
Virginia
Washington 270 2 280 1.77
West Virginia
Wisconsin 468 8 1,920 4.10
Wyoming 75 1 240 3.2
Source: National Association of Consumer Credit Administrators
79
EXHIBIT 4-10
INSTITUTIONS SUBJECT TO EXAMINATION BY STATE CONSUMER CREDIT
ADMINISTRATORS
(as of June 1971)
State
Small Loan
Companies
Other
Nonbanking
Financial
Institutions
Total
Number of
Examiners
Alabama
396
516
912
5
Alaska ,
Arizona
221
221
15*
Arkansas -
California
1,995
337
2,332
51°
Colorado
750*
750
4
Connecticut
417
10,948
11,365
10 p
Delaware
52
52
3*
District of Columbia
Florida
914
169
1,083
10
Georgia
1,112
1,112
12
Hawaii
212
47
259
18*
Idaho
Illinois
B00 q
227
1,027
8*
12
Indiana
Iowa
781++
354
378
732
16
4
Kansas
329
4,978
5,307
7 r
Kentucky
451
257
708
5
Louisiana
941
941
5
Maine
63
913
976
5 r
Maryland
340
380
720
6
Massachusetts
317
4,652
4,969
23 r
Michigan
600
188
788
8
Minnesota
115
415
530
5
Mississippi
425
193
618
8
Missouri
580
124
704
3
Montana
65
65
1
Nebraska
208
208
1
Nevada
63
63
4
New Hampshire
88
314
402
1
New Jersey
499
499
5
New Mexico . .
201
155
356
1
New York
553
759
1,312
317*
North Carolina
566
122
688
5
North Dakota
44
37
81
2
Ohio
1,556
1,164
2,720
11
Oklahoma
508
2,167
2,675
4 r
Oregon
233
62
295
2
Pennsylvania
926
7,821
8,747
22 s
Rhode Island
105
105
5
South Carolina
682
52
734
6
South Dakota
72
72
1
Tennessee
455
455
5
80
EXHIBIT 4-10 (Cont'd)
INSTITUTIONS SUBJECT TO EXAMINATION BY STATE CONSUMER CREDIT
ADMINISTRATORS
(as of June 1971)
Small Loan
Other
Nonbanking
Financial
Number of
State
Companies
Institutions
Total
Examiners
Texas
2,265
2,265
16
Utah
77
156
233
4 l
Vermont
33
33
6*
Virginia
380
380
2
Washington
270
69
339
2
West Virginia
204
204
12*
Wisconsin
468
2,974
3,442
8 U
Wyoming
75
75
1
687
* Responsible for examining all financial Institutions
+ Supervised lenders UCCC
° Responsible for examining credit unions as well
P Division performsTlL function for all lenders Including banks
q Industrial loan offices licensed but operated out of small offices
++ Figure only Includes small loan companies that will be subject to examination under UCCC, other supervised
lenders not determined
r Division performs TIL examination for retailers or unlicensed lenders
* Responsible for 1064 Motor Vehicle Sales Finance and 1431 Instalment Sellers
1 Includes premium finance companies and pawnbrokers
u Responsible for 2639 Motor Vehicle Dealer Sales Finance and 200Sales Finance
DATA SOURCES: National Association of Consumer Credit Administrators and Conference Df State Bank Super-
visors
81
Chapter 5
CREDIT INSURANCE
The term “credit insurance” here pertains to insur-
ance sold in connection with a consumer credit transac-
tion. 1 It covers the life and/or health of the debtor as
distinct from property insurance sold to debtors to
protect creditor’s equity in big ticket items-household
goods and automobiles— against perils such as fire,
windstorm, theft; and collision. (Fire and casualty
insurance is not covered in this chapter.)
The two basic types of personal credit insurance are
life and accident and health. Credit life insurance insures
tlie creditor against loss if the debtor dies. Credit
accident and health insurance insures the creditor against
loss if the debtor is disabled and cannot make payments.
Both assure the debtor that the debt will be paid and
that dependents will be freed of the obligation.
Debtors seem to accept credit insurance. An Ohio
University research group surveyed debtors, and asked
“If you were to borrow money in (the) future, would
you want the amount of the loan covered by credit life
insurance?” More than 90 percent of the respondents
answered “yes.” 2 An almost identical question concern-
ing health and accident insurance elicited about the same
percentage of affirmative response, indicating that most
debtors want credit life and credit accident and health
insurance.
The Nature of Credit life Insurance
Credit life insurance may be provided on an individ-
ual or group basis. To obtain an individual policy, the
debtor must negotiate for and purchase directly from an
insurance company sufficient coverage to pay the
approximate amount of the outstanding debt. This
typically is in the form of decreasing term insurance
with the face amount of the policy declining as the debt
matures or time passes.
Individual policies are rarely sold except in connec-
tion with home mortgages or similar types of instalment
credit in which the debt is relatively large and the time
over which instalments are to be paid is relatively long.
Individual coverage is not generally available for the
typical consumer instalment debt, because the relatively
small size and short maturity of the debt make such
coverage uneconomical. 3 Consequently, the bulk of
credit life insurance in force in the United States is in
group form. At the end of 1970, approximately $88
billion of credit life insurance was in force with
approximately 84 percent of it written on a group
basis. 4
Group Credit Life Insurance
The mechanics of underwriting and selling group
credit life insurance are significantly different from
those of individual credit life policies. Group credit
policies are issued by the insurance company directly to
the creditor. The group insured is a single designated
class of debtors, such as credit customers of a depart-
ment store or borrowers from a consumer finance
company. Each member of the group typically owes a
relatively small amount of instalment debt with a short
maturity, usually 5 years or less.
The typical group credit life policy provides that
upon the death of the insured debtor, the insurance
company will pay the unpaid balance of the obligations.
The creditor-policyholder is the beneficiary. Since the
policies provide decreasing term insurance for each
member of the group, the amount of insurance for each
member declines with reduction in the balance of the
debt, and the benefits usually equal the debt. If the
debtor becomes delinquent in payments and stays
delinquent for a specified period of time, the policy
usually provides for automatic termination. If the policy
did not so provide, the insurance company could find
itself exposed to an adverse selection of risks; for a
creditor could continue to pay premiums for insured
delinquent debtors whose deaths were imminent, and
stop paying premiums for all other delinquents.
Group credit life insurance policies usually stipulate a
limit on the amount that may be written on one insured
debtor. If the creditor extends credit in excess of the
maximum coverage available under the policy, the
amount of insurance usually remains at the maximum
until fire indebtedness is reduced to that maximum.
Thereafter the indebtedness and insurance are reduced at
the same rate. However, in some cases the policy
provides for a proportionate reduction in insurance. In
this instance, the insurance is reduced by the same ratio
83
as the debt. The amount of the insurance always bears
the same relationship to the amount of the debt. For
example, if the maximum limit for each life insurance
policy were $2,000 and the creditor should lend the
insured debtor $4,000, the initial amount of insurance
would be $2,000. With each succeeding payment on the
indebtedness, the amount of the insurance would be
reduced proportionally but insurance coverage would
always be equal to approximately 50 percent of the
unpaid balance of the debt. 5
Group Credit Life Premiums
Although the premium on group credit life insurance
is paid by the creditor-policyholder to the insurance
company, all or part of the premium cost may be passed
on to the insured debtor. In some instances creditors
provide credit life insurance to debtors without any
identifiable specific premium charge and absorb the cost
in the finance charge or the cost of the goods or services.
Credit unions are an example of a class of creditors who
do this. Typically, however, the debtor pays a specific
and identifiable charge for credit life insurance as a
separate service. It was tins controversial charge— what it
should be and how it should be computed-that was the
focus of the Commission’s interest.
Premium rates and consequent charges to debtors are
usually at flat rates (rates of charge for insurance which
do not vary with the age of the insured debtor or the
amount of insurance written). This differs from regular
life policies where the premium increases as the age of
the insured increases and the face amount of the policy
decreases.
Two methods of assessing premiums are the initial
single premium method and the periodic billing method.
The first and most common method is for the creditor
once each month to compute an initial single premium
for each new debt that has become insured during that
month and pay the aggregate of these single premiums to
the insurance company. Under this system the single
premium pays for coverage for the full term of the
indebtedness. The premium is usually computed at a flat
premium rate per $100 of initial indebtedness per year.
For example, on a $ 1 ,000 note repayable in 12 monthly
instalments, the insurance premium rate might be 39
cents per $100 of initial indebtedness per year, or $3.90.
The other method of determining and collecting
premiums is to charge the insured creditor a flat rate
periodically, usually monthly, on each $1,000 of out-
standing insured indebtedness. This method of premium
assessment is typically used when premium costs are not
passed on to the debtors as a specific identifiable charge.
If this method is used and the charge is passed on to the
debtor, the creditor may have an expensive problem
with delinquent insured accounts. The creditor may pay
insurance premiums on a debtor’s life and never collect
the premiums from the debtor.
State laws generally provide that any charge made to
a debtor for credit insurance may not be more than the
actual premium paid by the creditor to the insurance
company. The creditor is not allowed to take a
“markup” on the premium, and normally does not
receive a commission. That fee is usually paid to a
licensed agent of the insurance company. The creditor,
to whom the master policy is issued, receives his
compensation in the form of “dividends and/or rate
credits when earned, based on the experience of the
group.” 6 The amount of that compensation depends on
(1) the claims experience of the insurance company with
the creditor’s particular group of debtors and (2) the size
of premium charged. If the insurance company has a
large margin of underwriting profit (the difference
between premiums collected and claims paid) the divi-
dends or rating credits payable to the creditor are large
and vice versa. This method of computing compensation
provides the incentive for creditors to select those
insurance companies that charge high insurance premi-
ums, because high premiums tend to result in propor-
tionately higher compensation. This conflict of interest,
the focal point of the controversy, is the basis of the
iemand for specific regulation of all credit insurance
rates and/or sales.
Credit Accident and Health Insurance
Credit accident and health insurance also offered in
connection with consumer credit transactions provides
for payment of insured debt instalments falling due
while the debtor is disabled. It, too, is nearly always
written on a group basis 7 and marketed like group credit
life insurance. The major difference between these two
types of insurance is that a wider range of plans is
available under group accident and health.
Credit accident and health policies have two distinc-
tive features that affect premium costs, (1) the qualifica-
tion period and (2) the method of determining benefits.
Under almost all credit health insurance plans benefits
do not accrue until the insured has been disabled for a
period of from 14 to 30 days. Sometimes the plan
provides that benefits are retroactive to the first day of
disability, provided disability has continued past the 14
to 30 day qualification period. However, if benefits are
not retroactive, they are payable only for the period of
disability occurring after the qualification period.
Another difference between credit life and credit
accident and health insurance is the method of deter-
mining the amount of benefits to be paid. Under a credit
life policy, full benefits are payable on death. Under a
84
credit accident and health policy, one of two quite
different methods of determining benefits is usually
stipulated. The most commonly used is the pro rata
method which provides that the insurance company will
pay I /30th of a monthly instalment for each day the
insured debtor is disabled for less than a month, and, of
course, full instalments for each full month of disability.
The other method provides for a benefit equal to the full
monthly payment if the insured is disabled on the
monthly payment due date. Under either method
payments continue as long as the debtor is disabled up
to the contractual maturity date of the debt.
The insurance company charges a flat premium rate
for all borrowers regardless of age, as with credit life
insurance. The master policy is issued to the creditor
who in turn sells the insurance to debtors. In providing
credit accident and health coverage, creditors have the
same conflicts of interest they have with credit life
insurance. The creditor’s compensation is a function of
the charges to insured debtors for the insurance cover-
age. The higher the charges, the greater the creditor’s
compensation and vice versa. As a consequence, some
type of rate regulation has been demanded for this type
of coverage, just as it has been for credit life insurance.
Why Any Direct Compensation?
Senator Philip Hart and others have asked why a
creditor should receive any direct compensation or
profit from the sale of credit insurance. The justification
for compensation to the creditor is that the creditor
performs valuable third party services for the insurance
company and the debtor. These services result in savings
to the insurance company which are in turn passed on to
insured debtors. This can be proved by comparing the
premium for a credit insurance policy written on a group
basis with one written on an individual basis. The cost of
coverage is almost always less when written on a group
basis. In many cases the debtor does not have a choice
because few companies sell credit life insurance on an
individual basis, and none sell it on an individual basis at
reasonable rates.
What services are performed? First, the creditor
“acquires or sells” the insurance either for no commis-
sion or a lower one than if an agent were used.
Acquisition costs (e.g. sales commissions) are a major
cost for the life insurance company when an individual
policy is sold. Second, the creditor issues the evidence of
insurance to the debtor, collects premiums, and handles
other routine tasks of policy administration. The insur-
ance company may make periodic audits to determine if
the creditor is complying with group policy terms and
legal requirements, but most administrative tasks are
performed by the creditor. Finally, the creditor handles
claims administration. Evidence of death or disability is
submitted to the creditor who usually assists in complet-
ing the claims form and forwards it to the insurance
company. Then, the company pays the creditor-benefici-
ary who in turn remits any proceeds in excess of the
debt to the debtor’s estate (under a life policy) or to the
insured (under an accident and health policy).
The controversial areas associated with credit insur-
ance may be classified as (a) nonrate abuses and (b) ade-
quate rates. Nonrate abuses include such tilings as
(1) selling excessive coverage, (2) failure to refund to
debtors unearned premiums, (3) failure to inform debt-
ors of their coverage, (4) pyramiding of coverage and
(5) coercion of debtors to purchase insurance. 8 Correc-
tion of most of these problems is primarily, though not
exclusively, a matter of adequate legislation and enforce-
ment. That these practices are “abuses” is not the
subject of much controversy. Chief Counsel Robert A.
Miller of the Pennsylvania Insurance Department writing
on enforcement experience indicates widespread viola-
tions of the laws and regulations in that state. 9
The second basic problem in the regulation of credit
insurance involves establishing proper rates for credit life
and credit accident and health insurance. The contro-
versy continues because there is merit to several con-
tending positions.
The Pr oblems
Sale of credit insurance by creditors to debtors for
profit has been at issue for 15 to 20 years with
controversy stemming from two basic factors. The first
is that the creditor has a conflict of interest in the
purchase of group credit insurance from the insurance
company. The creditor’s compensation is directly related
to the premium charged for the group credit insurance:
the higher the insurance premium, the larger the
creditor’s compensation or profit for the services he
performs. Consequently, the contention is that the
creditor will tend to select group life policies with the
highest premiums— a form of “reverse competition.”
The second factor is that the debtor has no real
alternatives in selecting credit life or credit accident and
health insurance. The purchase of credit life or credit
accident and health insurance on an individual basis is
uneconomical and, by age group, would cost the debtor
considerably more than if purchased from a creditor on
a group basis. Consequently, the debtor’s choice is to
purchase the insurance from the creditor or not purchase
it at all.
The creditor is in an unusually powerful position to
“persuade” or “sell” credit insurance to debtors. This is
probably more likely in the cash credit (loan) segment of
the market than in the sales credit segment because the
85
typical cash borrower normally has fewer alternative
sources of credit available than the credit purchaser.
The debtor is usually in an inferior bargaining
position with tire creditor. The creditor or lender usually
will not openly and directly state that the purchase of
credit insurance is required for a loan or credit pur-
chase. This is particularly true since the Truth in
Lending Act (TIL) became effective, because under TIL
if credit insurance is required, the premium must be
included in the finance charge and, therefore, in the
annual percentage rate. However, it seems probable that
subtle pressure is used in the sale of the insurance to
debtors, evidenced by the unusually high percentage of
debtors who purchase insurance. It is not unusual for
cash lenders to have an “insurance penetration” of 95 to
98 percent. Even in light of the indicated preference of
borrowers for these coverages, these high percentages of
acceptance of insurance indicate that some coercion is
probably used.
Of course, debtors have no compelling reason to
resist this pressure, because the cost of credit insurance
is usually relatively small in relation to the total amount
of the average consumer credit transaction. The rela-
tively small cost and the high level of acceptability of
credit insurance tend to make this insurance relatively
easy to sell.
Normally, when buyers of goods or services are fully
informed of the price, terms, and conditions of a
transaction, competitive forces will establish a “fair”
price for the item, assuming the buyer has alternatives.
The problem with credit insurance is that even when
informed debtors have no real alternatives in selecting
coverage and are in a vastly inferior bargaining position
vis a vis the creditor. In addition, the relatively insignifi-
cant cost of the added insurance service discourages
debtors from engaging in intense price shopping.
Because the creditor’s interests tend to lie in higher
credit insurance rates rather than the lowest obtainable
rates, and because the economic factors are such that
debtors cannot or will not shop for credit insurance,
there is considerable pressure and probable justification
for governmental regulation of rates.
The problem is not whether there should be regula-
tion of rates but what type and how much regulation is
needed. The extreme positions regarding rate regulation
are represented by some who believe that credit insur-
ance rates should be determined competitively and by
others who feel strongly that the creditor should not
only be required to sell credit insurance on a nonprofit
basis but that he has a “fiduciary” responsibility to
obtain the lowest possible rates. The creditor’s obvious
conflict of interest would make competitively deter-
mined rates unlikely. Consequently, some type of
regulation is necessary to help encourage competition.
Relative Benefit Position
Some suggest that a possible solution to the problem
of regulating credit life and credit accident and health
insurance rates is to forbid creditors from making any
profit from the sale of the insurance. 10 The basis for
believing creditors would continue to provide this
coverage on a nonprofit basis is that creditors benefit
from credit insurance coverage even if they derive no
profit from its sale. There is no question that creditors
would benefit because the insurance indemnifies them
against loss of amounts owed by debtors who die or
become disabled. Then why not adopt this approach as
the solution to the problem? It has two major shortcom-
ings.
First, if creditors were not allowed to profit from the
sale of credit insurance, the number of creditors offering
the coverage would likely decline. Inevitably, as the
number of debtors covered by various group insurance
plans declined, the unit costs and price of this insurance
would rise. The price of credit insurance on a nonprofit
basis could conceivably be higher than it is on a profit
basis. 1 1
Second, this nonprofit approach, as most other
approaches to the regulation of credit insurance, changes
the economic nature of the credit insurance transaction.
The basic error in the nonprofit approach is the implicit
assumption that the consumer credit transaction yields,
or would yield, a reasonable return to the creditor
without the profit from credit insurance. Considerable
evidence indicates that this would not be the case. For
example, the 1971 composite financial report of the
regulated consumer finance companies operating in
Missouri indicates that without income from credit
insurance these companies in the aggregate would have
operated at a loss for that year . 1 2 It would be unrealistic
to assume that cash lenders would continue to offer
credit insurance if they were prevented from making a
profit. Indeed, it might be that cash lenders, under such
circumstances, would not only discontinue offering
insurance services but cease or severely restrict offering
financing services as well.
The Alternative Cost Position
Some believe that even the higher unregulated rates,
such as $1.00 per $100 or $1.50 per $ 1 00 per year, for
consumer credit insurance are not as onerous as many
proponents of regulation would have the public believe.
Group credit insurance sold by creditors to debtors even
at such relatively high rates, they maintain, is less costly
than similar coverage bought by the debtor on an
86
individual basis. This contention is correct for anyone for individual decreasing term life insurance shown in
over age 40 as demonstrated by the comparative rates the following table.
Single Premium Rates for $100 Initial Coverage, Monthly Decreasing Term Life Insurance for 12,
24, 36 and 60 Months at Various Ages.
Ages
12 months
24 months
36 months
60 months
18-25
$0.46
$0,638
$0,813
$1,159
26-30
0.481
0.679
0.877
1.276
31-35
0.53
0.776
1.027
1.548
36-40
0.659
1.036
1.433
2.293
41-45
0.948
1.596
2.273
3.715
46-50
1.394
2.467
3.587
5.972
51-55
2.123
3.878
5.693
9.516
56-60
3,265
6.070
8.970
15.020
61-65
5,006
9.377
13.762
22,539
Source: American Banker Life Assurance Company, Miami, Florida
Rates for group credit life insurance range from the
recommended rate of 60 cents up to 75 cents per $100
of coverage for 12 months. 13 Rates for individual
coverages shown in the table would be higher than group
rates for debtors over age 40 while such rates would be
lower than group rates for the younger debtors. 14 Thus,
it appears that younger debtors are subsidizing the credit
insurance coverage for older debtors. Even with the
suggested group rate of 60 cents per $100, a borrower
35 years old or younger could purchase credit life
insurance on an individual basis more cheaply than on a
group basis.
The effects of this apparent subsidy of older debtor’s
insurance by younger debtors may have greater signifi-
cance in the regulation of credit life insurance rates than
is apparent at first glance. If life insurance companies
and creditors are required to write credit life insurance
at flat rates of 60 to 75 cents of $100 initial coverage,
they could increase their profit simply by being more
selective in their risks. For example, creditors could
establish a rule that no credit would be extended to
persons over age 40 and eliminate higher risk older
debtors. The lower flat rate recommended by the
National Association of Insurance Commissioners
(NAIC) and others would tend to reduce cost of credit
insurance to younger debtors and deny it to older
debtors. To overcome this deficiency, some suggest that
a regulation be promulgated requiring creditors to offer
credit insurance to all debtors. But the probable result of
such a regulation might be that creditors would refuse
credit to older debtors because transactions with them
would be marginally profitable.
Actuarial Cost Position
The approach to regulation of credit insurance rates
with the greatest appeal and widest acceptance in
determining the allowable charge for credit life and
accident and health insurance is the actuarial cost of the
insurance plus a “fair” profit approach. It seems
reasonable to determine the “actual” cost of the
insurance, add a “fair” profit, and let the result be the
rate. 15 But administrative problems in applying this
approach make it unacceptable to creditors and insur-
ance companies, and, in fact, they use a drastically
modified version of the “true” cost plus a “fair” profit
approach.
True actuarial cost credit insurance would involve a
study of the mortality or morbidity costs, servicing
costs, and overhead costs of the insurance. It is obvious
that the mortality or morbidity costs would increase as
the age of the debtor increased, and rates for insurance
for older debtors should be higher than for the younger.
Similarly, rates for smaller initial debt balances should
be relatively higher than for larger initial balances,
because a fixed cost is involved with overhead and
servicing of the policy. The resultant rate structure
would involve progressively higher insurance rates as the
age of the debtor increased or the size of the initial debt
decreased.
For the most part, regulatory authorities have de-
cided that the variable rate structure allowing for
differences because of amount of debt and the age of the
debtor is too unwieldy and complex. The NAIC has
recommended that a flat rate system be adopted by the
496-072 O - 73 - B
87
various state regulatory bodies using “a single minimum
loss ratio standard for all credit life insurance transac-
tions irrespective of the size and the maturity” of the
indebtedness and the age of the debtor. An NAIC staff
study recommends that all credit insurance rates
allowed, accident and health, as well as life, should result
in a 50 percent minimum loss ratio. Credit insurance
rates for a particular company should be adjusted
upward or downward to conform with this standard or
benchmark of a 50 percent loss ratio. The basic
advantage of the flat or single rate system of regulation
using a basic loss ratio is its simplicity. Regulatory
authorities as well as insurance companies and creditors
could easily understand what the permissible rate of
charge for the credit insurance should be. The underly-
ing assumption behind the minimum 50 percent loss
ratio benchmark is that if the claims expense is equal to
approximately 50 percent of total premiums collected,
the remaining 50 percent, on the average, would be
sufficient to defray other costs associated with the
insurance and provide a reasonable profit to the insur-
ance company and the creditor. This 50 percent loss
ratio benchmark was recommended by NAIC for use by
the various states in setting both credit life and credit
accident and health rates according to the model bill.
There may be loopholes in the 50 percent minimum
benchmark loss ratio when used in connection with
accident and health insurance. The benchmark was
developed primarily from studies of credit life insurance
where the benefits were relatively fixed and the resultant
premium developed would be relatively constant. How-
ever, with credit accident and health insurance, there are
a number of different variations in plans, such as the
length of time in the qualification period and provisions
for retroactive benefits. The creditor can increase his
profit by selecting a credit accident and health plan with
1. Automobile loan for $3,000 - 36-month duration
Total Charge
Benefits
Insurer's Retention
Balance
2. Small loan $500 - 24-month duration
Total Charge
Benefits
Insurer's Retention
Balance . . . .
a shorter qualification period and retroactive benefits
which would produce higher claim costs and higher
premiums. These higher premiums result in greater
profits to the creditor. The following table presents a
comparison of the balances available for the dividend or
rating fund from which the creditor is compensated. One
credit accident and health plan is based on a 30-day
qualification period with nonretroactive benefits; the
other plan provides a 14-day qualification period and
retroactive benefits, 1 8
The balance available to a creditor for the 30-day
nonretroactive plan is about the same as for a credit life
plan. However, if a creditor decided to increase the
benefits which would result in an increase in premium as
with the 14-day retroactive plan, the balance available
for the creditor’s expense and profit nearly doubles. The
creditor’s costs in providing these insurance coverages
are relatively fixed and therefore these increases in
balances would be mostly profit.
The flat rate premium derived from the 50 percent
minimum loss ratio has flaws and results in inequities to
debtors, creditors, and insurers. As pointed out earlier,
under a flat rate system, younger debtors are subsidizing
older debtors’ credit insurance, because younger debtors
have lower mortality (claim) costs. The creditor who has
credit outstanding involving principally small average
balances, short maturities, and older debtors would be
penalized under a flat rate system compared with any
competitors whose portfolios included larger average
balances, longer maturities, and obligations of younger
debtors.
To overcome some of the inequities of the flat rate
system, the preliminary report of the Consumer Credit
Life and Disability Insurance Study at Ohio University
recommended a variable rate structure for credit life
A & H
A&H
30-Day
14-Day
Life
Nonretroactive
Retroactive
$54.00
$63.60
$125.40
-27.00
-31.80
-62.70
- 5.40
- 9.54
-18.81
$21.60
$22.26
$ 43.89
$ 6.00
$ 8.70
$ 17.65
- 3.00
- 4.35
- 8.83
- .60
- 1.31
- 2.65
$ 2.40
$ 3.04
$ 6.17
88
insurance based on the “cost and profit elements of the
credit life insurance transaction.” 19
The variable rate structure system proposed by that
study does not consider all cost elements in the
derivation of rates because the formula used to deter-
mine rates took into account only operating overhead
costs, acquisition costs, and servicing costs, plus a flat
rate for mortality or claim cost. Variability of the rate
stems from the fact that acquisition and servicing costs
decline proportionally as the size of debt and length of
time to maturity increase.
The formula used to determine the insurance rate (P)
per $100 of initial indebtedness per year is: 20
P =
4
3
S_
L
+
A = creditor acquisition cost for each insurance
transaction = $1.50
S = creditor servicing cost per year = 66 cents
C = claim cost per $ 1 00 of initial indebtedness per
year = 30 cents
M = maturity of the underlying credit extension in
years
L = size of the underlying credit extension in $100
units
It should be noted that this formula does not take
into account variable costs associated with mortality
because it provides a mortality or claim cost factor of 30
cents per $100 of initial indebtedness per year
irrespective of the age of the insured. While in no sense a
“true actuarial rate,” it does capture all of the variables
except mortality.
It would be more equitable to set maximum
allowable credit insurance rates on the basis of various
costs of the insurance transaction than to use the flat
rate system now employed. Such an insurance rate
structure contemplates broad categories of allowable
rates, taking into account differences in age, size of debt,
and length of maturity of debt. For example, one rate
would be set for all creditors between ages 20-29, a
higher rate for creditors between 30-39, and so forth.
Similarly, variable rates should take into account
differences in size of debt and length of maturity as
suggested by the Ohio University study. But as a
practical matter, the number of rate categories proposed
in that study should be reduced. The study
recommended a different rate for each $250 increase in
the size of debt and for each 6 months in maturities. The
full rate schedule called for 96 separate rates. While this
variable rate system has merit, for simplicity’s sake the
breakdown should be less detailed with fewer specific
rate classes.
The Commission recommends that the finance charge
earned by credit grantors should be sufficient to support
the provision of the credit service. If this goal is achieved
by the states, charges for all forms of credit insurance
should be set at a level to permit the provision of this
service, without subsidizing the finance service or being
subsidized by the income received from providing the
finance service. In short, credit insurance should stand
“on its own feet.”
The Commission had neither the time nor the
resources for a study to determine a “proper” loss ratio
or level of charges for all of the various forms of credit
insurance and differences among policyholders. Its
review of the literature and of Congressional hearings
gives reason to believe that rates on various forms of
credit insurance are too high in many states.
The Commission recommends that the proposed
Bureau of Consumer Credit in the Consumer Protection
Agency make a study to determine acceptable forms of
credit insurance and reasonable levels of charge and
prepare recommendations.
The Commission also recommends that the states
should immediately review their own charges for credit
insurance and lower rates where they are excessive.
The Commission further recommends that creditors
offering credit life and accident and health insurance be
required to disclose the charges for the insurance both in
dollars and cents and as an annual percentage rate in the
same manner as finance charges and annual percentage
rates of finance charges are required to be disclosed
under the Truth in Lending Act and Regulation Z. The
amount of premium and the corresponding percentage
rate should be set forth clearly and conspicuously on the
Truth in Lending disclosure statements just below the
annual percentage rate of finance charge. In that way,
consumers will be told the charge for credit insurance,
assuming the creditor offers credit insurance, in the same
way they are told the finance charge. Such disclosure,
particularly in credit advertising, should help provide a
competitive market in credit insurance.
89
Chapter 6
RATE CEILINGS
The Commission focused a substantial amount of its
attention and devoted a large share of its resources to a
study of the adequacy of existing arrangements to
provide consumer credit at reasonable rates.
Basically, there are two conflicting views on how to
assure reasonable rates for consumer credit transactions.
Some support “free rates,” arguing that prices of credit
should be established by tire market unhindered by
direct government interference. Others support “decreed
rates,” opting for price ceilings on consumer credit.
Spokesmen for the two viewpoints are both numerous
and dedicated. Econorhist Dr. Milton Friedman leaves no
doubt as to his position:
... I know of no economist of any standing, . . who
has favored a legal limit on the rate of interest that
borrowers could pay or lenders receive— though there
must have been some. . . . Bentham’s explanation of
the “mischief of tire anti-usurious laws” is also as
valid today as when he wrote that these laws preclude
“many people, altogether, from the getting the
money they stand in need of, to answer their
respective exigencies.” For still others, they render
“the terms so much the worse. . . While, out of
loving-kindness, or whatsoever other motive, the law
precludes a man from borrowing, upon terms which it
deems too disadvantageous, it does not preclude him
from selling, upon any terms, howsoever
disadvantageous.” His conclusion: “The sole
tendency of the law is to heap distress upon
distress.” 1
But economist Leon Keyserling does not agree:
I find it deplorable that we feel bound to set an 18
percent interest rate ceiling for these people, which is
three times the rate at which (as I have cited) a
powerful corporation can borrow money on bonds
while many of our greatest corporations finance
themselves and do not have interest costs of large
significance. I think the ceiling should be very much
lower ... I am not going to take the position that
even 12 percent is a conscionable interest rate for the
kind of people borrowing money for these kinds of
purposes. They ought to be able to borrow for much
less, even if this requires new public programs. 2
These differing viewpoints have existed for centuries.
HISTORICAL BACKGROUND
The basic economic choice of setting prices by a
free-market approach or by a price-control approach has
been faced from the time of tine first loan of grain, or an
animal, or food. Historical review suggests that each
society has had to “reinvent the wheel” in dealing with
the issue and has not learned appreciably from earlier
efforts. Current attitudes about the use of credit by
consumers and the prices they should pay for it are
conditioned by a long history of Biblical injunctions
against the taking of interest. The origins of society’s
views on interest rates help to explain some of the deep
feelings about this economic issue.
Ancient times
Records of primitive societies show rates for the use
of rice, shells, blankets, and cattle ranging from 100 to
300 percent. 3 ' One of the first attempts to limit the
maximum rate of interest was in the 24th centuiy B.C.
when the Laws of Manu in India set 24 percent as the
established rate. 4 During the Babylonian period
(1900-732 B.C.) the Code of Hammurabi set a
maximum annual rate of 33 1/3 percent for loans of
grain and 20 percent for loans of silver, although then as
today there were recorded violations of the legal
maxima. 5
Annual percentage rates on personal loans in Greece
In tlie fourth century B.C, were not limited by law; they
ranged from 12 percent to 33 1/3 percent from
professional money lenders but “common usurers”
charged considerably more. 6 This era also foreshadowed
remedial loan associations (“the temple at Delos charged
10 percent on all loans”) and the credit problems of the
cities (Senator Marcus Junius Brutus charged the city of
Salamis in Asia Minor 48 percent). 7 During the same
period the Romans attempted to limit the price of
credit. In 443 B.C. the legal maximum in Rome was
8 1/3 percent although market rates were evidently
higher. The price ceiling on credit was fixed at 4 1/6
percent in 347 B.C. but this ceiling was even more
frequently breached.* During 10 centuries beginning
with the fifth century B.C., ceilings on the price of
91
credit in Rome ranged from a prohibition of tire taking
of interest to 12 1/2 percent. Actual rates charged varied
with the same market forces of demand and supply
common today and were limited, if at all, more by
tradition than by legal ceilings. There were also, as
today, “pawnshop rates and ‘loan shark’ rates which
[were] far higher than the ‘normal’ rates.” 9
Religious Prohibitions of Usury
The contemporary meaning of “usury” differs from
its use in the Bible and in medieval Europe. Originally,
usury “signified a payment for the use of money
itself,” 1 0 whereas today usury is viewed as the taking of
a greater rate of interest than the law allows, The
Biblical injunction against usury was very simple: Do not
take back more than is given.
And if. thy brother be waxen poor, and fallen in
decay with thee; then thou shalt relieve him: yea,
though he be a Stranger, or a sojourner; that he may
live with thee.
Take thou no usury of him, or increase: but fear thy
God; that thy brother may live with thee. 1 1
Thou shalt not lend upon usury to thy brother; usury
of money, usury of victuals, usury of
anything. . . Unto a stranger thou mayest lend upon
usury; but unto thy brother thou shalt not lend upon
usury. 12
Because the original Biblical meaning of usury was
synonymous with modern-day “interest,” the effect of
the Biblical injunction was to prohibit the taking of any
return for a loan of money-or the loan of anything. The
origin of this doctrine lay in the belief that it was
morally wrong to profit from the distress of a
necessitous borrower. Restrictions against usury received
support in medieval and renaissance Europe from both
church and state, St. Ambrose (340-397) argued that
usury was acceptable only when used against the “foes
of God’s people” who could also be acceptably killed,
and the Capitularies of Charlemagne (circa 800) forbade
usury. 13 Prohibitions against usury were more strictly
codified in 1139 by the Second Lateran Council. Even
the time-price doctrine (which, of course, did not exist
in that era) came under prohibition when Pope Alexander
ill (1159-1181) “declared that credit sales at a price
above the cash price were usurious.” 1 4
Such artificial prohibitions against the taking of any
interest combined with pressures for credit by
consumers and commercial interests set into motion a
number of reactions.
First, there were outright violations of the usury
limitations, although the sin of usury was not viewed
lightly. Private pawnshops existed in medieval Europe
with rates ranging from 3214 percent to 300 percent and
some “illegal lenders” charging as high as 1300 percent
per annum. In the Low Countries during the 12th
century usurers were licensed at substantial fees by the
State which then proceeded to stamp out competing
unlicensed lenders 1 5 (an early version of modem
convenience and advantage licensing for consumer
finance companies in some states).
Second, an effort was made in the latter half of the
15th century to provide charitable or remedial loan
facilities for the poor. Developed in the tradition of the
temple of Delos in ancient Greece, these facilities were
early forerunners of the Provident Loan Society,
established in 1894 as “New York’s great ‘philanthropic
pawnshop.’ ” 16 The public pawnshops established by
papal governors have been described as follows:
A mons pietatis was a public pawnshop, regularly
financed by charitable donations and run not for
profit but for the service of the poor. It charged a
small fee for its care of the pawns and for the
expenses of administration, including the salaries of
its employees, so that the capital would not
eventually be exhausted by the costs of the business.
In Italy this fee came usually to 6 percent, as
compared with the 32 1/2 to 43 1/2 per cent charged
by public usurers. The directors of the mons were
usually one or two ecclesiastical representatives and
several respected merchants of the town. 1 7
Third, while the public pawnshops represented an
important attempt to provide credit to necessitous
borrowers through charitable organizations, sanctioning
of them by the 16th century Popes was a significant
break in the rigid definition of usury as the taking of any
return for tire loan of money. Theologians reasoned that
repayment of borrowed money that exceeded the
original principal was not usury but compensation for
the costs of operating the mons pietatis. This
redefinition of usury was expanded by medieval
schoolmen who reasoned that the lender should be
compensated not only for expenses but also for what
today would be termed the lender’s cost of capital— the
return earned by placing funds in investments of similar
risk. Conclusions of the medieval schoolmen may be
summarized:
. . . first, the poor and needy are deserving of loans
consistent with the costs and risks involved in making
them; and second, that if loans are to be made, there
must be incentives for capital to be rewarded on a
competitive basis with other market opportunities. 1 8
By the 16th century credit was widely used and
accepted and a competitive market for capita! emerged.
Usury became defined as the taking of excessive interest
rather than the taking of any interest. Between 1822 and
92
1836 the Holy Office of the Catholic Church “decreed
that all interest allowed by law may be taken by
everyone.” 19 It was not, however, until 1950 that Pope
Pius XII “declared that bankers ‘earn their livelihood
honestly,’” 20
Although the taking of interest became acceptable,
Biblical doctrines were not easily forgotten. England
decreed maximum rates of 8 percent (1624-1651) and 6
percent (1651-1714). 2 1 These 17th century rates,
brought to the Colonies, remain in many U.S. state laws
and constitutions today even though all English usury
statutes were repealed in 1854. 2 2
Origins of Rate Ceilings in the United States
The American Colonies and their successor states
followed the path taken by Massachusetts in 1641 when
it adopted a general usury statute fixing maximum rates
at 8 percent. They failed to follow Massachusetts’ lead in
1867 when it repealed its usury laws. Today only
Massachusetts and New Hampshire have no general usury
statutes or constitutional provisions decreeing a
maximum interest rate although both states have
statutes, such as small loan laws, that limit finance
charges on specified forms of consumer credit.
As it became apparent that credit could not be
extended to consumers, or even to many commercial
borrowers, at decreed rates of 6 to 8 percent, two
processes evolved to circumvent these price ceilings.
First, the time-price doctrine was developed.
Essentially, this was a legal principle permitting a seller
of goods and services freely to establish two prices, a
cash price and a time, or credit, price. Under common
law the differential was not considered interest subject
to general usury statutes. So, sales credit-credit
extended in conjunction with the sale of
merchandise became exempt from general usury
statutes which facilitated its growth. 2 3 Since 1 935 many
states have enacted legislation limiting the time-price
differential on the credit sale of motor vehicles and
other consumer goods as well as on revolving
credit.
Second, numerous exceptions to general usury
statutes were permitted for various forms of cash credit
that could not otherwise have been accommodated.
These exceptions opened up legal alternatives to
unregulated illegal lending that flourished in America in
the late 1800’s and early 1900’s in spite of usury laws
that presumably protected consumers. One report
showed 139 active loan offices— all illegal— in Chicago in
1916. 24
The first modern small loan bill, authorizing a
maximum annual rate of 36 percent on $300 loans, was
passed in New Jersey on March 13, 1914 with the
support of the Russell Sage Foundation. Similar
legislation eventually passed in most of the 50 states.
The first law establishing credit unions was enacted in
Massachusetts in 1 909. 2 5 Similar credit union laws were
eventually enacted in most states and at the Federal level
as well. Arthur J. Morris devised a means of making cash
loans to consumers through a combination of a direct
loan and a hypothecated deposit that provided an
effective return of about 17 percent, even if state usury
statutes set a rate ceiling on credit of 6 percent. The first
Morris Plan company began in 1910 in Norfolk,
Virginia. 26 Commercial banks entered the field of
consumer credit much later. The National City Bank in
New York was among the first to organize a personal
loan department in 1928. Eventually about 40 states
enacted special enabling laws permitting loans by Morris
Plan companies-or industrial banks as many were
called-and commercial banks at rates above the general
usury statutes. More recently special statutes have been
enacted to permit banks to make check-credit loans and
to offer retail revolving credit.
Not just consumers were considered in enacting
exceptions to usury laws. A host of exceptions were
made to accommodate the needs of industry and
commerce. Some 30 states exempt FHA-insured home
mortgage loans. 27 Thus, legislators, “though so far
unwilling to completely repeal usury laws, have filled the
statute books with exemptions which have taken care of
many of the situations in which usury laws interfered
with lending operations.” 2 8
Concluding a chapter on “Usury Doctrines and Their
Effect,” Sidney Homer remarks upon the continuing
controversy between those advocating decreed rates and
free rates on consumer credit transactions:
The controversy did not end with the Reformation
and the modification of Church doctrine. It
continued and continues. It is now couched largely in
terms of justice and expediency, laissez faire or
economic controls, controlled rates (supposed to be
low) versus free rates (supposed to be
higher), . , . The rate of interest in twentieth-century
America is often limited by law. It is still a subject of
controversy, not only among economists, but equally
among politicians and economic groups. Some like it
high; some like it low. 29
Such conflicting points of view are reflected in laws
affecting consumer credit both in the United States and
abroad.
93
CURRENT EFFORTS TO PROVIDE
CONSUMER CREDIT AT
REASONABLE RATES
United States
Review of the sequential development of legislation
affecting the rates charged for various forms of
consumer credit in the United States indicates that most
states have chosen to enact a great variety of rate ceilings
on most forms of credit. In contrast to the approach
adopted by most other developed countries, the states
generally have adopted a decreed-price approach to the
problem of assuring reasonable rates on consumer credit
transactions. These varying rate structures have created
substantial barriers to entry and diminished competition.
A compilation of consumer credit legislation 30
reveals the present, hodgepodge of legislation
characteristic of most states. As one example, New York
has separate statutes regulating instalment loans by
commercial banks, loans by industrial banks, bank
check-credit plans, revolving charge accounts, motor
vehicle instalment sales financing, instalment financing
of other goods and services, insurance premium
financing, loans by consumer finance companies, and
loans by credit unions. The general usury rate is 6 per-
cent: (currently 7 1/2 percent under special rule of the
Banking Board), and criminal penalties apply if interest
is over 25 percent. 31 But the decreed maximum rates to
obtain $500 of credit, repayable monthly over 12
months, range widely: bank personal and improvement
loans, 11.6 percent; industrial banks, 14.5 percent; used
cars up to 2 years old, 17.7 percent; used cars over 2
years old, 23.2 percent; small loan companies, 24.8
percent; other goods, 18.0 percent; retail revolving credit
1 1/2 percent on monthly balances up to $500 and 1
percent monthly on balances in excess of $500.
The variety of rate ceilings that has developed on an
ad hoc basis creates barriers to competition among
segments of the consumer credit industry. Given a
maximum rate of 1 1.6 percent in New York, commercial
banks will not enter the $500-loan market served by
consumer finance companies at 24.8 percent.
The Commission has noted the recent rush by banks
or bank holding companies to acquire finance
companies. For example. Bankers Trust New York
Corp., the parent corporation of Bankers Trust
Company, agreed to acquire Public Loan Company, a
New York based firm with 61 offices located primarily
in New York and Pennsylvania 3 2 where banks are
limited to a maximum of 6 percent discount on
instalment loans (11.6 APR on a 12-month loan). By
purchasing the finance company through its holding
company, Bankers Trust will enter a consumer credit
field previously denied it, in effect, by statute. Cash
borrowers in the two states would have been
significantly better off if banks had always been able to
charge the same rates permitted licensed lenders. The
added competition could only benefit cash borrowers.
Market segmentation created by rate ceilings has been
made even sharper by other restrictions on various
classes of credit grantors. For example, licensed lenders
in New York may lend no more than $1,400 to any one
borrower, whereas banks may make consumer loans as
high as $5,000. Such artificial market segmentation is
blatantly anticompetitive and fosters market domination
by relatively few firms.
Other countries
England bestowed on its Colonies usury limits of 6
and 8 percent, but repealed its own usury laws in 1854.
The only law governing rates charged for credit is the
Moneylenders Act of 1927. Chapter 10, (1) of the Act
provides that
. . . [w] here the interest charged exceeds 48 percent
per annum the court is to presume, unless the
contraiy is proved, that the interest is excessive and
the transaction harsh and unconscionable; and even
where interest does not exceed 48 percent per annum
this does not preclude the court from holding it
excessive. 33
This does not mean that there is a rate ceiling on cash
loans of 48 percent. If the facts warrant a higher rate, it
can be allowed— even if it is 80 percent per annum. 34
However, if the borrower brings action and the lender
cannot convince the court that the costs and risk justify
a rate above 48 percent, the court may reopen the
transaction and reduce the rate to a proper level.
Although finance rates charged on credit sales are not
currently limited, the Crowther Committee
recommended that the. 48 percent unconscionability
provision be extended to the whole field of consumer
credit on credit extension up to £2,000 (about $5,200).
The Committee emphasized, however, that the 48
percent does not represent the “fixing of an inflexible
ceiling,” 3 5 but rather that rates in excess of 48 percent
are 'prima facie excessive and the transaction harsh and
unconscionable with the onus on the creditor to show
that the rate is not excessive.
Canada repealed its general usury law in 1858. Its
Federal Small Loans Act 36 places a rate ceiling on cash
credit up to $1,500 extended by lenders other than
banks and credit unions. Maximum rates permitted small
loan companies range from 24 percent on $300 loans to
15.24 percent on loans of $1,500, with no limit above
$1,500. So few loans are made in the $1,000 to $1,500
94
range that the Royal Commission on Banking and
Finance recommended an increase in the rate ceiling for
such loans. 3 7
Finance rates on sales credit are not regulated by the
national government. Only one province— Quebec— has
adopted the decreed-rate approach. The rest have opted
for free rates, relying on Unconscionable Relief Acts to
permit the courts to determine what constitutes a “harsh
and unconscionable” credit charge. 38 These Acts apply
only to loan credit in five provinces; rates charged on
sales credit are not limited either by decreed rates or by
court tests of unconscionability. With the exception of
the Federal Small Loans Act and the Province of
Quebec, regulatory arrangements in Canada are similar
to those in England.
Germany has neither a general usury statute nor
special rate ceilings for consumer credit transactions. As
in England and Canada, reliance is placed primarily on
the market to set rates and the courts to remedy cases of
unconscionability. Both the Criminal Code and the Civil
Code contain provisions against loan sharking. 39 The
provisions do not define any given rate as being usurious
but indicate that a situation of unequal bargaining power
giving rise to charges out of proportion to benefits
received may constitute usury. 40
In France the general usury laws define as usurious'
any loan whose interest is more than 1 1/2 times the
interest charged generally in the credit market for loans
of similar cost and risk. 4 1 Rate schedules on instalment
sales transactions must be filed with the Counseil
National du Credit, but there is no indication that rates
are subject to maxima.
Belgium is one of the few European countries to limit
finance charges for personal loans and instalment
purchases. There is no limit on rates charged on very
small extensions of credit, under 2,000 Belgian francs
(about $45). The decreed rates decline from about 14 to
7 1/2 percent per annum on amounts extended up to
150,000 francs (about $3,400). No rate ceilings are set
for cash loans or instalment purchases involving amounts
of credit above that level.
The revision of the Austrian Instalment Credit Law in
1961 provided no rate ceilings. A few cantons in
Switzerland have limited finance charges on instalment
sales and small loans to 18 percent, but the Federal Law
on Instalment Sales enacted in 1963 contains no price
ceilings on extensions of credit.
New Zealand depends on the market to set rates
charged for credit. In a recent reassessment of this
position the Tariff and Development Board concluded:
. . . Because of numerous and varying factors which
might have to be taken, into consideration by a
supplier of finance in determining his finance charge,
the Board considers it impracticable to lay down any
statutory maximum for such charge. . .in any event,
any possibility of excess profit taking, as distinct
from a higher cost of service or risk on particular
transactions, would seem to be well controlled in this
country by the keen competition existing between
the companies engaged in instalment credit
financing. 42
Australia imposes no rate ceilings on the use of credit
but relies on the courts to reopen credit transactions to
deal with unconscionable finance charges. Apart from
such cases, a recent Commission there concluded that
“. . . we consider that interest rates are much more
satisfactorily settled by a free play of market forces.” 43
The approach taken by various states of the United.
States toward ensuring that consumers pay reasonable
rates for the use of credit generally contrasts sharply
with courses taken in other developed countries. Most
states fix rate ceilings on different types of credit and
credit grantors. Other industrial countries have generally
rejected the decreed-rate approach and permitted rates
on consumer credit transactions to be set by the free
market. Recognizing the possibility of occasional
unconscionable transactions, they have chosen to test'
these on a case-by-case basis in their courts.
PURPOSE OF RATE CEILINGS ON
CONSUMER CREDIT
Although the Biblical tenets against taking any return
for the use of credit have largely been rejected in today’s
society, other reasons have been advanced to justify
placing upper Emits on rates charged for the use of
credit— rate ceilings. These reasons include:
1. To redress unequal bargaining power.
2. To avoid overburdening consumers with excessive
debts.
3. To administer credit grantors as public utilities.
4. To assure that consumers pay fair rates for credit.
The. rate of charge is only one of a number of features
embodied in an offer of credit, just as price is only one
of the considerations in the purchase of an automobile.
The car buyer, for instance, is also interested in the
presumed durability, availability of repair services, style,
size, horsepower, gas mileage and gear ratio. The relative
importance of these different features varies among
consumers. This is true of consumer credit, too. If the
credit offer function is defined as the terms and
characteristics bound up with an offer of credit, some of
the more important aspects to consumers might be:
CREDIT OFFER FUNCTION
— Rate of charge
— Maturity
— Down payment (if any)
95
— Security required (if any)
—Availability of irregular payment plans
— Willingness of credit grantors to assume risk of default
— Convenience of location
— Status of credit grantor in view of consumer
— Collection methods
— Prepayment penalty
— Delinquency and deferral charges
As with automobiles, the relative importance of
different features varies among consumers. For example,
Juster and Shay found that “rationed” consumers— those
who wanted more credit than they were able to
get-ranked long maturities relatively high in their
preference scale while more affluent consumers were less
concerned witli maturities and more concerned with
price. 44
Complex as the credit offer function appears,
consumers apparently view the choice of credit as less
difficult than the selection of the item to be financed.
From personal interviews with 291 consumers who
purchased durable goods on credit, Day and Brandt
found that only 14 percent ranked the decisions of
(1) cash versus credit, and (2) credit source, as one of
the two most difficult decisions. In contrast, 77 percent
ranked as most or second most difficult “product
decisions” (1) amount to spend on the product,
(2) features or model, and (3) brand or make 4 5
In analyzing the purposes of rate ceilings and
examining their impact on consumer credit, the
Commission considered the following points:
(1) The rate of charge is only one aspect of the credit
offer function. Other features are not directly affected
by a rate ceiling but may be indirectly affected.
(2) The rate of charge is more important to some
consumers (probably the more affluent) than others
when they seek credit.
(3) Generally, but not always, consumers view the
credit decision as less difficult than decisions relating to
the product or service acquired. On credit purchases as
well as many cash loans, the demand for credit is derived
from the demand for a good or service.
To redress unequal bargaining power
Advocates of low rate ceilings on credit often argue
that the unequal bargaining power of debtors versus
creditors will allow creditors to charge what the traffic
will bear-the ceiling rate. Support for rate ceilings is
usually based on the assumption that most consumers
are not knowledgeable about the complexities of finance
charges, are incapable or unwilling to use Truth In
Lending information, and do not shop for credit. A
typical comment avers:
In most fields of consumer credit, with the exception
of new car financing, creditors charge the maximum
allowable rate, or close to it. 4 6
Do rates rise to rate ceilings? Staff studies show that
assertions that rates always rise to the ceiling are
incorrect except when the price ceiling is set at or below
the market rate for the particular form of credit placed
under price control. Persuasive evidence that rates do
not inevitably rise to the ceiling, available prior to
establishment of the Commission, 47 has been signifi-
cantly reinforced by the Commission study of rates
prevailing for various forms of consumer credit during
the second quarter of 1971. 4 8
Data gathered for the Commission relate chiefly to
the average rates (APR’s) and total amounts of credit in
each of 50 states. Exhibit 6-1 compares the ceiling rate
in each state with the mean APR charged by commercial
banks in that state for $3,000, 36-month direct loans on
new cars. To illustrate the construction of the exhibit,
the point circled represents data reported by commercial
banks in Hawaii. The ceiling rate on new-car loans in
Hawaii (under the Industrial Loan Act) is 24.85 percent.
On the random sample of prevailing rates for new auto
direct loans by commercial banks during the second
quarter of 1971, the average (mean) APR (as defined by
TIL) was 9.00 percent. Thus the point is plotted at
24.85 percent on the horizontal scale and 9.00 percent
on the vertical scale. Reported prevailing rates at
individual banks in Hawaii ranged from 7.21 percent to
10.64 percent.
The upward-sloping straight line represents the points
at which the average rates charged for new car loans
would be the same as the rate ceiling. For example, the
arrow under the legend “Mean APR = Rate ceiling”
points to the spot at which the mean APR and the rate
ceiling are both 20 percent. If the allegation that rates
always rise to the ceiling were true, all of the points
plotted for the 50 states would lie along tire
upward-sloping straight line. This is obviously not the
case. Even in the six states without a legal rate ceiling on
new car credit offered by commercial banks, average
rates are not higher than elsewhere in the country. In
those states the average APR ranged from 9.23 percent
(California) to 10.65 percent (Ohio). In half the 50
states, commercial banks reported average rates above
1 0.08 percent and half below.
Banks generally charge more for $1,000, 12-month
unsecured loans than for $3,000, 36-month direct loans
secured by new cars. This observation is borne out in
Exhibit 6-2, which compares the mean APR on $1,000
unsecured loans by banks with the ceiling rates. Two
points are worthy of note. First, mean APR’s vary more
widely under rate ceilings than in the case in Exhibit 6-1.
This suggests that other considerations-credit terms,
96
EXHIBIT 6-1
Comparison of Mean Annual Percentage Rate Charged by Commercial Banks for $3,000,
36-Month New Automobile Direct Loan to Rate Ceiling by State, Second Quarter, 1971
. 97
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98
borrower credit risk, and sellers’ market power— may be
responsible. Second, the market rates on loans of this
size and type seem to lie in the range from 12 to 16
percent. Rate ceilings below that range on $1,000 loans
of this quality usually approximate the rates actually
charged and force the mean APR’s below the other rates,
as shown in the left-hand side of the exhibit. Lower
decreed rates are accompanied by lower availability of
loans of this type from banks. Parenthetically, Exhibit
6-2 shows that the average APR reported by banks for
$1,000, 12-month unsecured loans in five states
exceeded the legal rate ceiling.
Finance companies compete in the area of higher
credit risks and succeed or fail on the basis of their skill
in making personal loans to applicants who will repay
and separating them from others who will probably
default. At mid- 1971, personal instalment loans
outstanding of finance companies amounted to about 14
percent of all consumer instalment credit outstanding.
In this market, conventional wisdom would have us
believe that 100 percent of instalment loans of finance
companies will be at the ceiling. The belief is tested in
Exhibit 6-3 which shows the percentages of personal
instalment loans made by finance companies during the
last 2 weeks of the second quarter of 1971 having APR’s
equal to or greater than 90 percent of the rate ceiling.
While it is obvious that a considerable proportion of the
loans are at or near ceiling rates, not all are within 90
percent of the ceiling. But there is little or no causal
relation between the height of finance company personal
loan rate ceilings and the proportion of loans equal to or
greater than 90 percent of the ceiling.
When a rate ceiling is set at or below the market rate,
rates actually charged are likely to be near or at the
ceiling. For example, when rate ceilings are set at
customary market rates, as with the 18 percent rate
ceiling on revolving credit in many states, significantly
lower rates would not be expected. Review of data
gathered by the Commission shows rates on $100
revolving credit balances commonly at or near 18
percent per annum, as disclosed by TIL, except in those
states where an even lower price has been decreed. 4 9
Findings thus far are summarized as follows:
(1) If the legal rate ceiling is set above the market
rate, the market rate prevails and average rates of charge
do not rise to the ceiling (Exhibits 6-1 and 6-2).
(2) Even in the cash loan market served by finance
companies where the emphasis is on nonprice competi-
tion, rates do not always rise to the ceiling (Exhibit 6-3).
(3) If price ceilings are set at or below the market
rate, rates will generally be at the ceiling. The precise
impact of this upon consumers has yet to be examined.
Do rates rise for other reasons? Commission studies
have provided some support for the notion that
consumers are not wholly knowledgeable about finance
charges and APR’s, nor do they appear to shop as
intensively for credit as they do for the goods financed.
Rates can be higher in some consumer credit markets
because ignorance and inertia among borrowers combine
with the absence of competition among suppliers. As a
result, unequal bargaining power may exist, and the
absence of alternative credit sources leads to higher rates
or restricted credit availability (or both) in such
consumer credit markets. Yet it is well established that
perfect knowledge and intensive shopping behavior are
not required to make a market workably competitive-
for the market to offer opportunities for credit at
reasonable rates. What is required is some proportion of
consumers who are willing to shift to lower price (rate)
sources in a market where credit grantors compete and
. where new competitors enter easily. As will be seen, the
use of rate ceilings to correct instances of unequal
bargaining power and an absence of alternative credit
sources is largely ineffective. On balance, rate ceilings
appear less desirable than policies to make competition
workable.
To avoid overburdening consumers with excessive debts.
On the theory that consumers cannot estimate how
much debt they can carry when acquiring a good or
service, some argue for rate ceilings on credit to prevent
consumers from becoming overburdened with debts and
subject to abusive collection tactics. They contend that
credit grantors who are permitted high rates will entrap
unwary consumers, overload them with debt, and then
use harsh tactics to collect. The theory is sustainable if it
can be shown that consumers who would pay rates
above ceiling are those who would become overindebted.
Generally, it is assumed that they would be. The line of
reasoning was well expressed in 1776 by Adam Smith,
usually an advocate of a free competitive market:
The legal rate, it is to be observed, though it ought to
be somewhat above, ought not to be much above the
lowest market rate. If the legal rate of interest in
Great Britain, for example, was fixed so high as eight
or ten percent, the great part of the money which was
to be lent, would be lent to prodigals and projectors,
who alone would be willing to give this high interest.
Sober people, who will give for the use of money no
more than a part of which they are likely to make by
use of it, would not venture into the competition. 50
What debts are excessive? A discussion turning on
excessive use of consumer credit should establish what is
meant by “excessive.” For some, it means a consumer
used credit, possibly at a fairly high APR, to acquire
something-a color TV set, or a big car-that the critics
consider unwise because of the consumer’s economic or
99
EXHIBIT 6-3
Percentage of APR's Personal Instalment Loans of Finance Companies Equal to or Greater than
90 Percent of the Rate Ceiling by States, Mid-1971
social status. To prevent this “prodigal” from such an
unwise decision, a low rate ceiling might force down the
permitted APR to the point that he is denied credit. The
Commission finds it repugnant to force a denial of credit
on many creditworthy borrowers by the imposition of
another’s value system.
Another meaning of “excessive” is simply an accumu-
lation of debt that a consumer is unable to repay in
accordance with the terms of his credit agreements, This
sensible definition avoids imposing one individual’s value
system upon another.
Do rate ceilings prevent excessive debt? A basic tenet
of our economic system is that most consumers and
creditors are rational. Banks and finance companies
responding to a Commission survey reported that
unemployment and illness were the first and third most
important reasons, respectively, for debtors’ failures to
meet their obligations. At the time they obtained credit
these consumers made rational decisions that were later
upset by unexpected events. Lowered rate ceilings would
not have prevented them from wanting to use credit.
The second most important reason cited was
“overextension of credit.” This represents an error in
judgment by both creditor and consumer; both
incorrectly estimated future cash flows to meet the
promised payments. Although it is in the self-interest of
each party to avoid such errors, they do occur. How
does lowering the rate ceiling affect mutual errors of
judgment? Governmental lowering of rate ceilings forces
lenders offering cash credit to take less risk, narrowing
the market they are willing to serve. Consumers are not
so constrained; they are even more eager to take on
obligations at the lower rate. But because the lender
makes the ultimate decision to accept or reject a
consumer’s promise to pay, he will deny more
applications at the lower rates, assume less risk, and limit
overextensions of cash credit.
Bad debt and collection expenses are significant
factors in the total operating expenses of credit grantors,
so creditors have every incentive to lend only to those
consumers who have tire potential ability to repay.
Should a credit grantor decide that a 4 percent bad debt
loss ratio is the maximum to be tolerated under existing
rate ceilings, he will attempt to lend to no higher risk
class than the one in which 24 out of 25 credit
applicants can be expected to repay. If rate structures
are lowered, operating expenses must also be lowered to
maintain profitability and if, as a result of lower rate
ceilings, a decision is made to reduce the tolerable bad
debt loss ratio to a proportion lower than 4 percent the
creditor would have to reject more applicants, because
every 25th person— unidentifiable at time of applica-
tion-will not repay. Commission data indicate that
finance companies currently reject more than one out of
two new credit applicants and one out of three of all
credit applicants, including present and former bor-
rowers. Given these rejection rates, the Commission is
not prepared to propose any rate ceiling that might be
needed to prevent overextension, prefering instead to
leave that to tire marketplace.
But overextension of cash credit is only a part of the
problem. A consumer with less than a prime credit rating
who wishes to borrow cash to shop for a TV set may be
rejected by all cash lenders because they cannot afford
to serve him. But he can still obtain credit at credit
retailers if they can merely transfer part of the finance
charge into the cash price of the goods and services sold.
Even if the ceiling price for credit were set at zero
percent, consumers could still become overburdened by
purchasing goods and services on credit. They do so
today from some credit retailers who make no explicit
charge for the use of credit. In such situations, a rate
ceiling does not prevent consumers from becoming
overextended when they are tempted to buy beyond
their means. It merely narrows the range of credit
sources available and puts the credit retailer in a more
powerful bargaining position relative to the consumer
who desires credit.
In the third of his classic letters, In Defence of Usury,
Jeremy Bentham concluded his version of the foregoing
analysis by noting:
As far as prodigality^ then, is concerned, I must
confess, I cannot see the use of stopping the current
of expenditure in this way at the fosset, when there
are so many unpreventable ways of letting it run out
at the bung-hole. 5 1
The potential for harassment of consumers by
creditors exists irrespective of levels of rate ceilings. The
remedy for harassing collection methods lies not in
changing the level of rate ceilings but in effective
legislation to inhibit those practices. As Commission
hearings in June 1970 brought out, legislation is often
adequate but enforcement insufficient.
Furthermore, lowered rate ceilings for the use of cash
credit increase the likelihood of unconscionable
collection tactics because the :high risk consumer must
turn to illegal lenders for the cash credit he needs. Such
a consumer does not report vicious collection procedures
for fear for his life and property and that of his family.
If in the cash loan field the aim is to protect consumers
from heavy-handed collection efforts, a lowering of the
rate ceiling is counterproductive for less affluent,
high risk consumers.
The Commission, aware of the importance of
protecting those whom Smith described as “prodigals
and projectors” from becoming overextended, finds that
the placing (or lowering) of rate ceilings on consumer
credit does not accomplish that objective. Its recommen-
dations to deal with this problem (Chapter 3) put
101
emphasis on the need to provide creditors with every
incentive to avoid overburdening consumers by limiting
creditors’ remedies and outlawing harsh collection
practices.
To administer credit grantors as public utilities
An alternate purpose of setting rate ceilings on
consumer credit transactions would be to assure that
consumers are charged rates sufficient to allow creditors
to earn a fair return on assets used and useful while
providing “adequate” service (however measured) to
consumers. This might be termed the public utility
approach to rate regulation.
This approach recognizes that if consumers are to be
served, rate ceilings must be high enough to permit
credit grantors to earn an adequate rate of return on
their invested capital. Otherwise, they would shift their
resources to some other business. An understanding of
the costs of providing consumer credit as discussed in
Chapter 7 is important in assessing whether or not rates
are “too high;” but to employ a public utility approach
to the setting of price ceilings on the use of credit
involves much more than a mere understanding of costs.
Most regulation of public utilities limits the prices
that may be charged by a firm to which some
governmental body has granted a franchise. Usually,
public utilities are monopolies. For example, a city or
state will grant a franchise to only one electric power or
telephone company, Such firms are not complete
monopolies, of course, since there are alternative sources
of power and communication. But credit grantors are
not granted franchises. They generally compete with one
another more vigorously than most public utilities. Each
city typically has a number of banks, credit unions,
finance companies, and retailers offering consumer
credit. In addition, a consumer may be able to obtain a
loan by mail, borrow on his life insurance policy, or use
one or more credit cards. In contrast, a consumer
wishing to light his home has no realistic alternative to
using electricity and only one source of electric power.
There is a basic theoretical problem in treating credit
grantors as public utilities. If a rate commission
permitted credit grantors to earn some given percentage
return on “assets used and useful,” 52 each credit grantor
could select whatever risk class of customer he wished to
serve. Over time the costs of providing credit to that risk
class would require the rate commission to approve
credit prices sufficient to cover those costs and earn the
prescribed return. In effect, the price ceiling for each
creditor would be set on a “cost-plus” basis and would
be a self-fulfilling result of the risk class served.
To avoid setting price ceilings for consumer credit on
a cost-plus basis under such a public utility approach, a
rate commission would have to specify in some manner
the highest risk class of consumers that could and should
be served by each credit grantor. Unless the rate
commission were then prepared to examine the validity
of credit turndowns for each franchisee, credit grantors
operating under a fixed rate ceiling could improve their
profit margin by denying credit to riskier consumers and
by not offering costly forms of credit, such as small,
short-term loans. The establishment of credit standards
and appropriate prices for multifaceted credit arrange-
ments and the enforcement of requirements that credit
grantors meet any “justified” demands by consumers of
widely varying credit standings pose dire problems for a
rate-making commission governing franchised consumer
credit grantors.
There are practical difficulties to treating credit
grantors as public utilities, too. First, there are severe
problems involved in cost measurement, particularly
among commercial banks, many finance companies, and
retailers. Most credit grantors offer a variety of
consumer credit agreements, and many engage in other
activities as well. Because of the problems of joint costs,
it would be extremely difficult and expensive to allocate
costs and revenues among the various activities and types
of credit of credit grantors. Second, in the case of sales
credit it would be difficult for a rate commission to
determine whether or not a credit seller was evading the
specified price ceilings on the credit service by reducing
quality of his goods and services or by inflating their
cash prices. Finally, if each of the thousands of grantors
of consumer credit were subjected to the same scrutiny
as each gas and electric company, telephone company,
and every other public utility, the Nation’s law and
business schools would not be able to supply the
requisite numbers of attorneys and accountants to do
the job.
It should be added that an error either in theory or in
application of public utility regulation to consumer
credit grantors would have a much more immediate
effect upon users of credit than upon consumers
dependent upon present-day utilities. An electric power
company has a large investment in fixed assets and will
continue to supply electricity for many years even
though the rates granted are inadequate. So long as
revenues cover marginal costs, it will stay in business
until it becomes necessary to replace plant and
equipment. In contrast, the assets of most credit
grantors are highly mobile. If a commission provided
inadequate rates, prospective credit grantors would not
enter the state and those operating in that market might
leave or severely curtail their activities. This was the
history in New York between 1941 and 1967 when the
legislature and Banking Department attempted to adopt
a public utility approach to setting rate ceilings for
102
licensed lenders. Since the Department selected a
permitted return on “assets used and useful” that was
significantly below the rate necessary to attract capital
into the industry, the consumer finance industry
languished during the period. 5 3 History provides at least
three cases where states have pushed rate ceilings on
loans by licensed lenders so low that legal lenders were
forced from business. 54
Thus, the evidence shows that the public utility
approach to the regulation of consumer credit grantors
is theoretically neither sound nor feasible.
To assure that consumers pay fair rates for credit
Tire most compelling problem to be considered is
whether rate ceilings assure that consumers pay “fair”
rates for credit. The crucial questions deal with whether
rates are fair for some, for all, and for whom if not for
all. Additionally, there is an immediate problem in
judging the fairness of rates without judging the
associated terms under which credit is granted. This
package the credit offer function— is complex with
features having differing values to different consumers.
These features should properly be taken into account in
determining if a consumer is paying a fair rate. Finally,
there exists no generally acceptable standard for what Is
a fair rate. 55 Notwithstanding this complexity, it is
possible to consider the impact of rate ceilings in terms
of a two-dimensional credit offer function: rate and risk.
The underlying assumption, of course, is that consumers
who pose a high risk to the credit grantor must pay
higher rates, other things being equal. Although the
following analysis is set in terms of this two-dimensional
credit function, it is equally applicable to the actual
multidimensional function.
Cash credit. About 30 percent of outstanding
consumer instalment credit originated as personal cash
loans and another 10 percent as direct automobile loans
by commercial banks. In the analysis of the effect of
rate ceilings in this field it is assumed that the ceilings
cannot be evaded and are enforced. 5 6 As pointed out in
Chapter 5 on credit insurance, the finance charge earned
by credit grantors should be sufficient to support the
credit service, and charges for credit insurance should be
at a level sufficient to support the insurance
service-each service should be economically independ-
ent of the other. Thus it is assumed here that a decreed
reduction in rate ceilings on credit cannot and should
not be offset by increased income from some other
credit related source such as credit insurance premiums.
Consumers present different levels of risk to a
potential credit grantor. The creditworthiness of
consumers is often measured by application of
credit-scoring techniques, and tire resulting distribution
of credit scores— credit risk— typically looks like diagram
A. A large proportion of consumers is grouped within a
middle range of risk, but there are significant numbers
who pose a considerable hazard to a potential creditor.
Many potential borrowers who are creditworthy may
not use consumer credit because they can draw on
savings to meet their needs.
It becomes progressively more costly for lenders to
serve consumers who present an increasing hazard of
credit loss. Not only do bad debt losses rise but the cost
of collection efforts also grows. Consequently, rates in a
competitive market without rate ceilings should rise as
credit is provided to consumers of higher and higher risk.
What are the effects of imposing price (rate) ceilings
upon cash credit, first in a competitive market and then
in an imperfect market? The impact may be examined
with the aid of diagram B. The curve represents the
cumulative numbers of consumers in progressively higher
risk classes. Put another way, it is a cumulative
distribution of the bell-shaped curve shown above.
Risk class of consumers
103
496-072 0 - 73-9
Price (rate)
ceiling
on cash loans
Cumulative number of
consumers at or below
given levels of risk
adding successively more risky consumers from left (low
risk) to right (high risk).
In a perfectly competitive market without any price
ceiling, consumers in the risk class shown in the diagram
at point Rjj would pay 25 percent and those at the point
Ra would pay 20 percent. If a price ceiling of 20
percent were imposed, it would be fair only for the
consumers at the point Ra. But it would be too low for
any risks higher than Ra risks. Given the higher
collection costs and bad debt losses that would be
incurred by serving those customers posing higher than
Ra risks, no consumers above the point Ra could be
served by legal lenders. They must be rejected and must
either postpone their use of cash credit, seek credit from
sales creditors (where a portion of the finance charge
may be incorporated in the cash price of the goods), or
turn to illegal lenders. The 20 percent ceiling rate would
be above the fair rate for borrowers of better quality
than Class A— that is, those to the left of Ra- Under a
competitive situation these consumers would pay the
rates that they deserve, whether a price ceiling was
present or not. Thus, under competitive conditions the
imposition of the price ceiling would be injurious to
consumers above Class A and superfluous for those in
Class A and better.
In contrast, assume that the market for cash loans is
imperfectly competitive. Cash lenders appear to exercise
strong market power in some states. Further, there is
evidence that not all consumers shop carefully for their
credit and compare rates of charge on the basis of
information provided by TIL. Does the imposition of a
20 percent rate ceiling on cash credit provide significant
protection to these same classes of consumers by
assuring that they pay a fair price for their credit? The
position of the consumers above point Ra is unchanged;
they are rejected because legal lenders have no incentive
to provide unprofitable credit at the decreed rates. s 7
Class A consumers, as well as consumers whose risk is
less, may be helped if, in the absence of the rate ceiling,
they would otherwise pay as much or more than 20
percent to obtain cash loans. If they fail to shop wisely
for credit, for example, they may pay more than 20
percent-quite possibly much more than they should
pay, given their risk class. Thus, rate ceilings may allow
some better credit risks to pay less in imperfectly
competitive markets, but only at the expense of die
higher risk borrowers who are excluded from the
market. As noted before, rate ceilings may cause a
transfer of credit costs to cash price in sales credit.
It would be fallacious to assume that higher risk
consumers thus denied legal cash loans would forego
their desired credit-financed consumption, Some will
turn to sales credit where some portion of the finance
charge may be buried in the cash price of the good or
service. Others may turn to the illegal loan market. Their
fate was graphically described to the House Subcom-
mittee on Consumer Affairs by Professor John Seidl:
Criminal loan sharking contains three necessary
characteristics in my opinion. First of all is the
lending of cash at very high interest rates by
individuals who are reputed to be connected with the
underworld The second characteristic is a bor-
rower-lender agreement resting upon the borrower’s
willingness to pledge his and his family’s physical
well-being for the proceeds of the loan Third is
the belief by the borrower that the lender has
connections with ruthless criminal organiza-
tions Twenty percent continues to be an
104
important element in the small-loan charge today.
The rate in some urban areas for small loans is 20
percent per week... 1,040 percent per an-
num .... In other urban areas, the rate is 20 percent
for a 6- or 10-week period with interest charges added
to the principal and the total repaid in weekly
installments .... Twenty percent add-on for a 6- to
10-week period produces from approximately 200 to
350 percent per annum. 58
The difficulty is that most consumers forced from the
legal cash loan market into the hands of loan sharks are
represented in no statistical sample, pay rates that are
unreported and undisclosed, and must remain mute
when legislatures lower price ceilings on consumer credit
in well-intended efforts to afford greater “protection” to
some other borrowers. Without presuming to pass on
constitutional issues, the Commission must at least raise
the question of whether it is desirable for the state to
deprive one group of consumers access to cash credit by
rate ceilings while permitting more affluent consumers
to obtain cash credit.
Sales credit, The remaining 60 percent of outstanding
consumer instalment credit is in the form of sales
credit-credit granted in conjunction with the credit sale
of consumer goods and services. If these markets are
perfectly competitive, each consumer would presumably
pay the rate appropriate for his risk class. In a
less-than-perfect market, not even consumers who
deserve just the ceiling rate are assured of paying a “fair”
price because of an option not available to cash lenders.
If a cash lender is denied a rate above, say, 20 percent,
he cannot serve consumers deserving to pay rates higher
than 20 percent because he cannot enhance his
combined income from credit and credit insurance. In
sharp contrast, a credit retailer operating in an imperfect
market and denied the opportunity to charge more than
20 percent directly may earn a higher rate indirectly to
the extent that he can exercise his option to raise the
cash prices of the goods he sells.
Clear evidence that low income retailers raise the
price of goods to finance higher risk customers is
provided in the Federal Trade Commission’s 1968 study
of the credit and sales practices of retailers in the
District of Columbia where little or no cash credit
existed in low income areas. Although the average of
APR’s charged by low income retailers was about 4
percentage points higher than the rates of general market
retailers to finance a sewing machine with a common
wholesale price of $100, the average cash retail price of
the low income retailer was $297 compared with average
cash prices of only $196 at appliance stores and $174 at
department stores. 59 Differences in cash prices of $101
to $ 1 23 obviously greatly outweigh the small variances
in the dollar amount of the finance charges. (In spite of
their much higher cash prices, retailers in the low income
market generally reported lower average returns on their
net worth than did general market retailers.) 60 The time
price charged in the low income' market may or may not
be justified. But if only a portion of that time price- the
finance charge or time-price differential-had been
limited to a rate below the rate, charged, there still would
have been no effective cap on the total time price which
combines both the finance charge and the cash price.
Because of the possibility of transferring all or some
of the finance charge into the cash price in imperfect
markets, the only effective means of protecting
consumers in the kind of market surveyed by the FTC is
to introduce more competitive alternatives, especially in
the form of cash credit. A fairly significant portion of
the power of the inner city retailer to raise his “cash”
price stems from the lack of convenient availability of
cash credit. Because no small loan offices operate in the
District of Columbia, low income consumers must travel
to Maryland or Virginia if they wish to borrow from
legal lenders, or are forced to buy from credit retailers
where they have little choice but to pay significantly
higher time prices than available to other consumers who
can get cash credit.
Forcing rates on sales credit below market rates has
two consequences:
1) Reductions in availability— In recent years there
has been considerable pressure to force down the ceiling
prices of sales credit, particularly revolving credit-both
retail and bank credit card. Were extreme rate reductions
forced on cash credit, the effects would be seen
immediately: cash credit would become unavailable-just
as small loans are for low income consumers in the
District of Columbia. But the effect on consumers of a
forced reduction in the price of sales credit is more
subtle and complex although the unfavorable impact
may be no less than that caused by a corresponding
reduction in rate ceilings on cash credit.
Forced reduction in the decreed maximum rate on
revolving credit to 10 percent per annum (as in
Arkansas) or from 1 Vi percent to 1 percent per month
(as in Minnesota, Wisconsin,* and Washington) have a
twofold effect on consumers. First, credit sellers may
make less credit available for the same reasons discussed
in the section on cash credit. Or, second, they may try
to make up the loss in income from some other source.
As Professor William C. Dunkelberg of Stanford
University concluded in a research report prepared for
the Commission:
The total volume of credit extended by firms will
likely fall; certainly, less credit (or at best, no more)
*Legislatively raised to l'A percent per month effective March
1973.
105
will be available at a lower rate such as 12%. The
incidence of this reduction in availability will not be
random in the population of consumers, but will fall
primarily on low income or otherwise disadvantaged
consumers. 6 1
By applying the credit-scoring systems used by a large
bankcard service to families included in the representa-
tive sample of U.S. families covered in the 1967 Survey
of Consumer Finances, 62 Dunkelberg could identify
those families who would be denied credit if the lowered
returns from providing credit forced an increase in the
minimum score necessary to obtain credit: ...
If 20 were the minimum score, raising the minimum
to 25 would eliminate 556 families that qualified on a
20 point criteria. Over 70% of those eliminated would
have a family income of under $5,000 per year. Over
90% would have incomes below $7,500 per year.
Thus, the incidence of the rationing would fall
heavily on the lower income families. It is these
families that have the fewest financial options and for
many of these families, credit buying would become
an impossibility or would be available only at much
higher rates . . . 63
2) Forced subsidy— A second effect of forcing rates
on sates credit below the level that would be set by the
market may involve the forced transfer of a portion of
the finance charge into the cash prices of goods and
services. At the outset it should be recognized that
retailing is a highly competitive business, largely because
entry and exit are relatively easy and frequent. Some
assessment of the degree of competition is provided by a
comparison of net profits after Federal income taxes as a
percentage of stockholders’ equity in 1969 for
manufacturing firms and retailers: 64
Percent
All manufacturing 11.5
Total durable 1 1.4
Motor vehicles 12.6
Primary iron and steel 7.6
Lumber and wood products 13.0
Color
Television
Little Rock $100.00
Texarkana, Texas 94.26
Monroe, La 96.47
Greenville, Miss. 97.18
Springfield, Mo 96.95
Percent
Total nondurable 11.5
Food and kindred products 7.9
Chemicals and allied products 12.8
Leather and leather products 9.3
Department stores (by sales volume in millions)
$1 - $2 2.73
$2- $5 7.73
$5- $10 4.85
$ 10 - $20 6.19
$20- $50 5.81
Over $50 7.74
All department stores 7.3 1
Whether or not it is desirable to legislate low rate
ceilings to gain further reductions in the rates that may
be charged for sales credit is basically a matter of social
policy. The question has been asked, “Should retailers
make money on finance charges as well as on goods?” 65
But the question avoids the issue. Retailers must make a
profit on their total sales of goods and services
(including credit services) to remain in business. There
are substantial costs in providing credit, and the low
level of retail profits provides no evidence of any
monopoly control over the market. So, the only real
issue is who should bear these credit costs— credit buyers
or cash buyers. Somebody must bear them.
The Commission’s econometric studies of sale credit
are summarized in Chapter 7; but the problem which
arose in those studies in explaining the relationship
between rate ceilings and availability was the lack of a
variable to measure differences in the prices of goods
sold on credit. Other studies, however, have obtained
data and provided evidence to support the hypothesis
that price and other adjustments occur if credit is to be
continually made available. In 1968, for example,
Gene C. Lynch found that prices paid in Little Rock,
Arkansas were higher than those paid in cities in other
states for a group of identical appliances. Forming an
index with a base price set at $100 for Little Rock,
comparable prices in the neighbor-state cities were found
to be: 66
Washer &
Dryer Refrigerator Range
$100.00
$100.00
$100.00
95.94
96.83
99.34
98.15
95.99
94.48
96.30
97.35
93.64
99.64
97.07
93.14
106
It can be argued that a forced reduction in the price
of revolving credit is desirable if credit buyers are paying
excessive rates in relation to the costs of providing
credit. Consumers using credit to acquire goods are
likely to be less sensitive to the price of credit than to
the much larger cash price of the item purchased. Yet an
examination of the costs of providing credit at retail
stores suggests that, even at a typical charge of 114
percent on monthly unpaid balances, the gross finance
charge does not cover the full economic costs of
providing the service. This point was made in hearings on
the Consumer Credit Protection Act by Joseph W. Barr,
Under Secretary of the Treasury, in response to a
question from Congressman Lawrence G. Williams: 6 7
MR. WILLIAMS. From your familiarity with
credit transactions is there any additional expense
connected with these revolving accounts that could
conceivably justify an 18-percent annual interest
rate?
MR. BARR. I don’t believe that is an exorbitant
rate. These are frequently small accounts and I am
not saying that revolving credit is a bad thing. I think
it is a great thing. It is the charge account principle
that was once limited to a few affluent people and
has now moved across the whole economy. But when
you have millions of small credit transactions— with
bookkeeping charges and credit examinations and
other costs— I doubt that you can make money at
much less than 18 percent.
One set of data may be cited to demonstrate the
cost-price relationships. In a survey of 15 stores with
annual revolving credit sales of over $402 million,
Touche, Ross, Bailey and Smart found that revenues
from finance charges amounted to 6.08 percent of sales
and costs of providing the service amounted to 8.39
percent of sales, leaving a deficiency of 2.31 percent. 68
So, even before the recent cuts in the permissible
maximum revolving credit rates in several states, cash
buyers seemed to be subsidizing credit buyers.
There is no logical reason to select any type of
product or service sold by a retailer and legally require it
to be sold at a loss. When credit is selected as the
required loss leader, the burden of subsidy falls primarily
on cash buyers, some of whom may have been unable to
obtain credit. Thus state laws that put the price of credit
below competitive rates are forcing both the wealthy
and the less affluent, who do not use or cannot obtain
credit, to subsidize the use of credit by others. Such laws
also tend to discourage those who can obtain credit from
using cash to buy goods. In the Commission’s view,
lowering rate ceilings on revolving credit below Yh
percent per month has on balance been contrary to the
best interests of consumers. -Indeed, in view of
documented costs of providing credit, it appears that the
required reduction in finance charges has forced some
retailers into a position approaching deceptive mer-
chandising. As shown in Chapter 10, the Commission is
concerned with offers of “free” credit when, in fact, the
cost of the credit service is buried in the cash price of
goods sold on credit. Consistency requires no less
concern when laws, in effect, force a transfer of some
part of the price of the credit service into the cash prices
of goods and services.
Regardless of the costs of providing any form of sales
credit, a reduction by legislative fiat of the permitted
gross income from finance charges necessitates adjust-
ments in goods prices, fees, or availability. If not,
lowered profits will force some retailers— probably small
ones-out of business. While credit sellers may recover
part of their lost income by reducing other services or
adding fees for services previously furnished without
charge, the most likely offset is an increase in cash prices
resulting in a subsidy of credit by cash purchasers.
Related Issues Affecting Rates
At times legislatures pass laws that seem to affect
only the methods of assessing finance charges but in fact
actually change the rate ceilings. For example, a
requirement that credit grantors offer consumers a
30-day “free period” on all revolving credit would really
be a reduction in rates for banks that offer revolving
cash credit because they do not typically offer such a
free period. If there is a valid economic reason for
prohibiting a charge for the first 30 days of a credit
transaction, it has escaped Commission attention. But if
such a “free” period is deemed a “fair” or desirable
policy, it should be remembered that the impact of the
change will reduce the rate ceiling APR and that the
probable effect on cash and sales credit will take the
form described in preceding sections.
Another issue is whether or not credit grantors should
be permitted a minimum charge for extending
credit-such as the initial charge on a taxi meter
regardless of the length of the journey. Some may view
it desirable to eliminate such charges, but the effect on
extensions of small amounts of credit again will be as
previously outlined. Cash lenders will find it un-
profitable to make small loans (just as cab drivers denied
an initial charge find it unprofitable to make short trips)
and those offering sales credit will reduce the availability
of small credit sales and attempt to recover lost income
in higher cash prices. Some consumers may gain, others
will lose. There is no convincing evidence that on
balance consumers will be better off. If the premise is
granted that it is only fair for creditors as a group to
recover the costs of providing credit, the same reasoning
should apply to the granting of small versus large
amounts of credit. Minimum charges are to cover costs
107
associated with the credit function regardless of the size
of the balance. That line of argument would support
minimum charges, both as a matter of equity and as a
deterrent to the uneconomical use of credit.
Another much-debated problem is how those offering
revolving credit should be permitted to assess their
monthly finance charges. One aspect of the issue is to
identify a system that is fair to consumers. But the
selection of a particular system as a matter of law also
effectively raises or lowers the rate ceiling.
With regard to the issue of fairness to consumers, the
Commission believes, first, that firms providing revolving
credit should deduct any credits for returns and
allowances before determining the periodic balance to
which the periodic rate is applied. A consumer who has
had to return merchandise bought on credit has
evidently received little or no benefit from its use and
should not be asked to pay a finance charge on its initial
unpaid balance. Second, charges for purchases and
credits for payments should at least be treated
symmetrically within a billing period. Specifically, no
finance charge should be made for a purchase within a
billing period unless credit is also given for any payments
received within the same period. Third, within these
guidelines it is important to leave open as many
reasonable options as possible. Were all retailers forced
to levy charges on the basis of die average daily balance,
for example, most small retailers would be unable to
assume the expense of compliance and would be forced
to adopt bank credit cards. Such a result would not only
be noncompetitive but would also reduce consumer
options.
CONCLUSION
On the basis of a summary of the historical approach
to the establishment of rate ceilings and institutional
knowledge about them the Commission must conclude
that, on balance, rate ceilings are undesirable when
markets are reasonably competitive. Imposition of rate
ceilings on consumer credit transactions neither assures
that most consumers will pay a fair price for the use of
credit nor prevents overburdening them with excessive
debt. The public utility approach to rate making in the
field of consumer credit is neither theoretically sound
nor feasible although it can serve as a reminder that
legislators must recognize the relationship between costs
and credit sizes if they do set rate ceilings.
The Commission did determine that current
knowledge about the effect of rate ceilings on the price
and availability of consumer credit was not sufficiently
precise to be used as a basis for recommendations
regarding rate ceilings. For this reason, the Commission
undertook its own technical studies based on empirical
evidence collected in the marketplace and presents its
findings in Chapter 7. Before this research was
undertaken by the Commission, there were no national
estimates of rates of charge for various types of
consumer credit nor detailed estimates of amounts of
consumer credit extended or outstanding on a state or
regional basis. Lack of state-by-state estimates of
consumer credit had prevented research scholars and
others from making thorough studies and analyses of the
effects of differences in state laws— including rate
ceilings-and other factors on the availability of
consumer credit and rates of charge for it. Nor had it
been possible to study the effectiveness of competition
among states, because any evaluation of market
performance requires knowledge of the level of prices
and quantities of output. The Commission staff
collected the data necessary to make these analyses and
comparisons, and Chapter 7 discusses the implications of
these data.
108
Chapter 7
RATES AND AVAILABILITY OF CREDIT
(Editor’s note: Material in this chapter is highly tech-
nical and utilizes concepts and language from the
discipline of economics. )
ISSUES, THEORY, AND OVERVIEW
From the preceding review of interest rate ceilings—
on historical, institutional, and legalistic bases— two
principal findings emerged: (1) Although social control of
the credit industry by means of rate ceilings may seem
morally, ethically, or paternalistically laudable, a policy
aimed at obtaining and maintaining competition was
found preferable. (2) Where legal rate ceilings have been
imposed, they affect average market rates of charge only
in a few credit markets. In practice they appear to be
largely superfluous. Further, they may generate a false
sense of security that social policy governing the
industry is adequate for the public interest.
No recommendations were made on the basis of these
findings because policy formulation, including rate
ceiling policy, greatly depends upon answers to two
further fundamental questions:
1. If legal rate ceilings do not appreciably affect or
determine observed average rates of charge in most
credit markets (by state and type of credit), then
what factors actually do determine observed aver-
age rates and, in particular, what is the role of
competition in the determination of rates?
2. What is the relationship between observed rates—
whether legally determined or “market”
determined— and the availability of consumer
credit?
The first question is important— and remains unanswered
despite the analysis of Chapter 6— because the observa-
tion of market rates below ceiling rates does not
necessarily imply the existence of workable competition
in the marketplace. If competition is inadequate, cor-
rective policy changes are required— the basic policy
options being lower rate ceilings or encouragement of
greater competition. The second question is important
because its answer will point to which of these options is
preferable or what mixture of them should be developed
if competition is found to be inadequate. Availability
and market rate are so related that legally determined
rates may adversely affect availability and that of course
would constrict the use of rate ceilings as a policy tool
benefiting all consumers.
The following brief, summarized answers to the
questions on “rate” and “availability” draw heavily from
simplified economic theory and the exhibits of the
preceding chapter. Basically, what is required is an
understanding of probable relationships between market
price, legal price, and availability under two alternative
competitive conditions— “intense competition” and “im-
perfect competition.” Empirical evidence from staff
studies (to be examined later) confirms the validity of
hypotheses based on economic theory reviewed here.
Intense Competition
A highly competitive market exists when the number
of sellers is so large and entry is so easy that no seller has
power over price (in this study, annual percentage rate).
Price is determined by the interacting forces of supply
and demand. In Figure 1 this is shown by the intersec-
tion of supply (a positive function of price because
costs, particularly risk costs, rise with increased quan-
tities supplied) and demand (a negative function of price
because greater, quantities are demanded as price falls).
The market price, Pc, is the only price for which supply
and demand are equal. Under these conditions the
relationships between rate ceilings, market price, and
quantities supplied and demanded (availability) can be
easily outlined. -
Al. If the price ceiling is above the competitive
market rate (Pc in Figure 1), the ceiling will affect
neither the observed market price nor the amount
supplied, because the interactions of supply and demand
are operative.
A2. If the price ceiling is below the market. rate (Pc
in Figure 1), the rate ceiling will determine the observed
market rate and the quantity supplied will fall as the rate
ceiling falls. This is shown in Figure 2 where Pl is below
Pc, and Ql is the amount supplied under the imposed
lower price. There is excess, unsatisfied demand because
the cost factors of the supply curve dominate. So long as
109
Figure 1
the rate ceiling is above Pc, the legal price rises or falls
without affecting the market price. On the other hand,
when the legal price is below Pc, it directly lowers the
amount supplied. This is shown in Figure 2 by com-
paring the quantity QL with Qc. The effect is more
diffuse when legal rate ceilings are set below the market
rate charged for credit by a seller of goods. Although
that somewhat restricts the supply of credit, some
portion of the finance charge may be driven into tire
cash prices of goods and services sold on credit.
Imperfect Competition
B. When a few firms possess market power in a
particular market, they may charge higher than com-
petitive market prices if it is more profitable for them to
do so. With this condition, price could be as high as, say,
Pm in Figure 3, which can be called the monopoly price.
Monopolies do not raise price indefinitely; there is some
optimum beyond which they will not go. For varying
degrees of market power which are less than monopoly,
the market price will vary between Pm and Pc. To the
extent that market power declines, thereby increasing
availability and reducing price towards Pc, the market
may be described as being “workably competitive.” Here
relationships between legal rate ceiling, market price,
and supply (availability) can be outlined as follows:
Bl. If the rate ceiling is above the market price, Pm,
it will affect neither the market price nor supply.
Variations in market price attributable to differences
prevailing in market power will be negatively associated
with the quantity of credit extended because demand
“dominates” in the price range between Pc (competitive)
and Pm (monopoly),
B2. As the legal rate ceiling falls, it will begin to
impinge on the market rate and determine amounts of
credit offered. This is shown in figure 4. In the range
from Pm to Pc, the amount of credit supplied will rise as
the price (which equals market price) falls because of
demand side dominance. But as the ceiling continues to
fall below Pc, say down to P3, the amount of credit
supplied falls just as it did for the purely competitive
case in paragraph A2 because supply (cost) factors then
dominate. To repeat, some portion of the finance
charges on sales credit will be buried in the cash prices of
goods and services sold on credit.
The resulting relationship between the legal ceiling
and quantity is depicted in Figure 5. Above the level at
which market power would set the observed rate, Pm,
no
Figure 5
Legal Rate i
in
the ceiling has no relationship with supply. As the ceiling
falls, it first increases supply (in the Pm to Pc range) and
then causes it to fall.
In light of these theoretical considerations, it is
possible to provide theoretical answers to the “rate” and
“availability” questions. First, if state legal rate ceilings
are not low enough to affect appreciably the observed
rates of charge, such factors as the intensity of competi-
tion, the level of production costs, and the strength of
demand will determine the market rate. Second, when a
relatively low legal rate ceiling does determine the
observed market rate, it also affects credit availability (a
lowering of the ceiling typically curtails the amount
supplied). Third, lowered ceilings on sales credit may
force cash buyers to subsidize credit buyers to some
extent.
An empirical validation of these answers is a difficult
and complex task. The staff of the Commission could
not, for instance, trace these relationships through time
for a particular type of credit in any local or state
market because no single market experienced sufficient
changes in conditions for such a test. However, since
relevant conditions do vary across states, the staff could
conduct a cross-section econometric analysis using mid-
197 1 data from the Commission’s survey of the industry
together with data from other sources, particularly the
1970 Census of Population. That analysis led to the
following simplified summary of conclusions:
a) The analysis of state markets for new automobile
credit discloses a situation consistent with the descrip-
tion of paragraph B1 depending on the state. In all but a
few states, rate ceilings are inconsequential as a deter-
minant of the market rate (see Exhibit 6-1, Chapter 6).
Also, observed quantities of credit extended vary in-
versely with market power (measured by market concen-
tration).
b) Retail revolving charge account credit is typified
by the descriptions of A1 and A2. Apparently competi-
tion in general merchandise retailing is sufficiently
“workable” to prevent large variations in price or supply
which could be explained by a lack of competition. In
approximately 1 1 states, rate ceilings for this type of
credit are relatively low, with results such as outlined in
A2. The remaining states seem to fit the A1 description.
c) Other consumer goods instalment credit market
conditions vary. Behavior governing direct OCG instal-
ment credit from financial institutions appears to be
explained by Bl, as in the case of new auto credit.
Retailer behavior for this type of credit is also best
explained, in general, by the Bl description, though in
some states B2 might be more appropriate because
ceilings are partially operative.
d) Legal interest rate ceilings have their greatest
impact in state markets for personal loans (Exhibits 6-2
and 6-3, Chapter 6). Competition in many of these state
markets is sufficiently constrained, often by rate ceil-
ings, to permit the application of descriptions Bl and
B2.
In sum, the empirical answers to the “rate” and
“availability” questions are generally consistent with the
theoretical answers. Competitive conditions are a major
determinant of rates and availability in the many state
markets in which legal ceilings are sufficiently high to
leave the market rate unaffected. This finding does not
argue for the imposition of lower rate ceilings, however,
because rate ceilings cannot be adjusted as precisely as
required if adverse effects on availability are to be
avoided. Empirical evidence indicates that rate ceilings
that impinge on market rates are also associated with
substantial reductions in credit supply.
These empirical findings are next reviewed in greater
detail for each of the major types of consumer credit-
new auto credit, other consumer goods credit, and
personal loans. Specific recommendations for policies
designed to improve competition are then presented.
Aware that workable competition will not be achieved in
the near future in all states, the Commission makes
temporary recommendations concerning legal rate ceil-
ing policies that it feels are appropriate until competitive
conditions become satisfactory. Since these recom-
mendations are in large part grounded on cost considera-
tions, a discussion of costs precedes the recommenda-
tions.
FACTORS INVOLVED IN DETERMINING
RATES OF CHARGE AND THE
AVAILABILITY OF CREDIT
Credit availability can be defined conceptually as the
degree to which creditors are willing to provide credit at
the free market rate in a world without imperfections.
Although this ideal market is still far from reality, the
definition can be used to assess the relative availability
of credit under the imperfect market conditions that
deviate from the ideal. This section outlines the factors
involved in determining the availability of credit in
competitive and in imperfect markets.
Availability in a Competitive Market
In an ideally competitive market, rates reach com-
petitive equilibrium levels through a series of adjust-
ments by suppliers of various credit offers to various risk
classes of consumers. 1 These rates are high enough to
cover costs and enable creditors to earn a normal return
on invested capital. Creditors are willing to extend any
amount of credit to qualified borrowers at such rates,
112
and the situation can be characterized as one of full
availability.
Economic forces affecting availability of credit differ
from those that determine, say, the availability of men’s
shirts. A retailer who sets a price of $7.50 per shirt is
willling to sell shirts to all customers at that price. In
contrast, a finance company that sets a rate of 18
percent for a 24-month unsecured loan for $ 1 ,500 is not
willing to serve all applicants at that price. The lender
envisions a certain minimum credit standing to be met,
and will reject as many as two out of three new
applicants willing to borrow at that rate.
Even in a workably competitive market, credit
grantors find it uneconomical to adjust the price of
credit precisely to variations in operating costs resulting
from differences in the terms of the contract and in
perceived risk. A retailer may levy a flat 50-ccnt delivery
charge within a metropolitan area, regardless of the
distance traveled or the size and weight of the package.
A finer discrimination in delivery charges might cost
more than the greater revenue (or equity) achieved.
Similarly, credit grantors often “pre-package” credit
offers and in pricing the packages ignore some variations
in the costs, A finance company may offer 30 and
36-month new car contracts but not 32-month con-
tracts; and the APR may be the same on both the 30 and
36-month contract, despite possible differences in costs.
Under imperfectly competitive conditions, many
credit grantors set a “house rate” for potential cus-
tomers and accept all consumers sufficiently credit-
worthy to meet the house rate. A bank with an APR of
12 percent on all 30 and 36-month direct new car loans
may accept all customers whose risk class deserves that
or a lower rate and reject those in a higher risk class.
Under perfectly competitive conditions, a creditor
would have to give a rate consistent with the customer’s
risk or lose the business to another creditor who would.
At present, a very good customer may negotiate a lower
rate single-payment loan or even a lower rate on an
instalment loan.
Aside from the expense of providing a variable rate
structure attuned to cost and risk, creditors now hesitate
to make adjustments because of difficulties in explaining
why one customer must pay a higher rate than a friend
who gets credit at the same source. Also, until the fairly
recent development of credit-scoring systems, creditors
had little scientific justification for varying rates accord-
ing to perceived risk. Such systems are still not used by
all credit grantors and so cannot yet be relied upon to
determine a variable rate structure based on perceived
risks among all classes of borrowers.
Because of the tendency to establish a “house rate”
in the consumer credit field, even in workably com-
petitive markets consumers are likely to find a wider
variation in rates— and availability— among different
types of credit grantors than among firms of the same
type. The range of rates on personal loans is greater
across industry lines among credit unions, banks, and
finance companies than it is among credit unions alone.
Put another way, high risk consumers are likely to find
credit more available at finance companies at higher
rates than at credit unions and banks at lower rates, but
will probably not find great differences in availability
among finance companies. This tends to segment the
market somewhat despite considerable overlapping of
rates and a great deal of interindustry competition on
other aspects of the credit agreement.
Factors that Restrict Availability
In general, any kind of market imperfection— any
restriction which tends to inhibit the free interactions of
potential borrowers and suppliers of credit— can have a
potential effect on credit availability. Such market
imperfections include legal constraints, regardless of
intent, as well as noncompetitive behavior of suppliers.
Legal factors of most potential significance are rate
ceilings, restrictions on other credit terms such as loan
size and maturity, limitations on creditors’ remedies, and
legal constraints on the entry of new firms.
The restrictive effect on availability can occur in two
basic forms: a price effect and a nonprice rationing
effect. In the first case, which arises from noncom-
petitive behavior of credit grantors, credit prices are set
above the free market- rate that would otherwise occur
and result in a level of credit extensions lower than the
free market level. Nonprice rationing occurs when credit
terms, such as loan size and maturity, are made too
restrictive for potential credit users or when credit
suppliers refuse to serve some qualified credit applicants.
The various causal relationships fall into five groups.
Legal rate ceilings. The effect of restrictive rate
ceilings is to limit the number of borrowers who qualify
for legal credit and reduce the amount of credit supplied
(Chapter 6). In some instances a restrictive rate ceiling
may also lead to an increase in market concentration. If
less efficient suppliers are forced out of the market
because they cannot compete at the restricted price, the
remaining firms will then control a larger share of the
market. Then if the degree of market concentration is
sufficient to induce noncompetitive behavior, credit
availability will be further reduced. Sales credit rate
ceilings may cause creditors to shift a portion of the
finance charge into the cash price, thereby forcing cash
buyers to subsidize credit buyers. Such ceilings probably
also force some firms from the market, leading to greater
concentration.
113
Restrictions on loan size and maturity. Legal restric-
tions specifying the maximum amount or maturity of
credit can result in terms that are unacceptable to some
potential credit users. Consumers most likely to be
affected by these limitations are those in the risk class
most commonly served by finance companies and by
retailers catering to high risk credit buyers. These
consumers often desire as much credit as possible with
low monthly payments. Faced with an artificial restric-
tion on maturity or size of loan, for example, a potential
high risk borrower has four main alternatives: (a) to seek
a loan at another source which has no restriction, (b) to
reduce credit expectations and accept the small loan,
(c) to attempt to obtain two small loans, or (d) to do
without. The first alternative is usually not feasible for
the typical borrower served by finance companies. The
second, like the first, results in reduced availability from
the finance company sector. The third, termed “dou-
bling up” in the trade, may overcome the restriction on
availability but usually results in significantly higher
costs (because of graduated rate structures, two small
loans are commonly more expensive than one larger loan
and this is a form of restriction on availability).
Limitations on creditors’ remedies. Restriction on
creditors’ remedies make the creditors’ position less
favorable than if they had full use of all legal collection
tools. In the face of limitations on remedies a creditor
can either (1) increase rates to cover added collection
costa and bad debt losses or (2) maintain the same rates
but exercise more selectivity in granting credit. To the
extent that borrowers are sensitive to rates charged for
credit, the first option will find less demand for credit at
the higher price. The second will result in fewer qualified
borrowers. Both will result in reduced availability. 2
Barriers to entry. Because the principles of free
competition are based in part on ease of entry for new
suppliers, any barriers to entry can lessen competition.
Barriers are not limited to the commercial bank, credit
union and finance company sectors studied by the
Commission, It is possible that savings and loan associ-
ations and mutual savings banks could stimulate com-
petition if allowed to broaden their consumer credit
activities in states which now restrict them. Another
significant legal barrier in consumer credit markets is
that of convenience and advantage (C & A) licensing for
finance companies under many state laws. By limiting
licenses under strict construction of the law to offices
that serve the “convenience” and “advantage” of the
community, states inhibit competition from new firms.
Although the intent of C & A licensing is purportedly to
encourage the growth of the size of loan offices to attain
economies of scale, misdirected application of the rule
can lead to substantial lack of competition. Moreover,
Commission studies reveal no significant economies of
scale. 3
Market concentration. When it leads to the exercise
of market power, market concentration can affect
availability in two ways. First, the traditional exercise of
market power is indicated by an increase in prices
followed by a reduction in the amount of credit
demanded. Second, firms may ration credit by refusing
to serve some qualified borrowers. By accepting only
selected credit risks, a firm can maximize its excess
profits.
The New Automobile Credit Market 4
Commission findings on the price and availability of
new automobile credit, presented in this section, cover
(1) the structure of the market to illuminate subsequent
interrelationships among various sectors of the market;
(2) the associations between those factors and the price
of new automobile credit at commercial banks and
finance companies; (3) the availability of new automo-
bile credit; and (4) conclusions about the observed
operations of the new automobile credit market.
Market structure. Major suppliers of automobile
credit are banks (including mutual savings banks), credit
unions, and finance companies. Commercial banks may
participate in two ways: (1) direct lending, and (2) the
purchase by banks and finance companies of consumer
instalment contracts (purchased paper) from retail auto-
mobile dealers (termed “indirect financing”). The na-
tional market share for each of the major supply
components studied is shown in Exhibit 7-1.
EXHIBIT 7-1
National Market Shares of Major Sources of New
Automobile Credit Extended, Dollar
Amounts, Second Quarter, 1971.
Source
Percent Market Share
Bank direct loans 32.3
Cred it u nion direct loans 1 5.4
Bank purchased paper 29.8
Finance company purchased paper 22.5
100.0
Source: Data are based on the National Commission on Con-
sumer Finance 1971 Consumer Finance Survey (un-
published)
The structure of the market can be viewed from two
perspectives: either the demand for credit (the borrower
view) or the supply of credit (the supplier view). From
the borrower’s standpoint there are four alternative
institutional sources of credit— banks (including mutual
savings banks, and other miscellaneous lenders), finance
114
companies, credit unions, and (to a limited extent)
automobile dealers. Because credit unions lend only to
members, their market is more restricted than that of
banks and finance companies. However, 29 percent of
the loans outstanding at Federal credit unions at
mid-1970 were made to finance automobiles, 5 and their
share of the consumer instalment credit market has
increased steadily over the past decade.
On the supply side, the bulk of retail sales financing
of new automobiles comes from three credit sources-
commercial banks indirectly, finance companies indi-
rectly, and retailers, themselves. Automobile dealers
typically sell their instalment contracts to more than one
financial institution. Generally, there is a gradation of
risk acceptable to financial institutions, with finance
companies usually willing to accept a higher average
degree of risk than commercial banks. For example, a
dealer may sell a very prime contract to a commercial
bank and charge the customer a relatively low rate,
knowing the customer might otherwise borrow directly
from his bank or credit union. An instalment contract
arranged with a less creditworthy consumer might be
rejected by the bank and sold to a finance company.
Since the finance company and dealer perceive the
higher risk, the consumer is likely to pay a higher APR.
The dealer’s participation in the finance charge-the
difference between the buying rate of the finance
company and the rate charged the consumer-may also
be higher than on the contract sold to the bank, if the
dealer’s agreement with the finance company requires
that he repurchase the car in the event that it is
repossessed. Finally, the finance company may be
unwilling to finance a very risky consumer unless the
dealer agrees to pay off the contract in event of default.
To offset his still greater risk, the dealer will charge that
consumer an even higher rate than in the previous two
cases. Consumers are typically told by the dealer that he
is arranging to sell the contract to a bank or finance
company where payments must be made,
Mainly by use of advertising direct lenders compete
with automobile dealers for the business of new car
customers. Potential new car purchasers, then, can
arrange for credit at the dealer’s or obtain direct loans
from banks, finance companies, credit unions, or other
financial institutions with choice presumably based on
knowledge of differences in prices and availability.
Rates of Charge (APR’s) for New Auto Credit
How are the several market rates of interest (APR’s)
related to each other— are they positively intercorrelated
across states, or do variances tend to be random in
relation to each other? The answer to this question at
the outset is important, because if certain reasonably
clear patterns of association are apparent, the explana-
tions for the associations must first be sought out. If,
however, there appears to be little or no interstate
association among the rates, the rates for each source
could be discussed without regard to possible inter-
dependencies.
Exhibit 7-2 presents a correlation matrix of the
interstate variances of interest rates charged on new auto
credit by major credit grantors, with commercial banks
and finance company direct and indirect customer rates
shown separately. Inspection of the matrix discloses that
many of the rates are, indeed, highly correlated. By
definition some of the correlations should be significant.
For example, the indirect customer rates for banks and
for finance companies are each comprised of a dealer
participation rate and a net indirect institutional rate. It
is to be expected, therefore, that tire commercial bank
indirect customer rate would be highly correlated with
the commercial bank dealer participation rate and the
commercial bank indirect net rate. Similarly, the signifi-
cant correlation between finance company indirect
customer rate and its two components— finance com-
pany dealer participation rate and finance company
indirect net rate— came as no surprise. Indeed, the
definitional relationships generate some of the highest
correlations in the matrix— particularly the correlation
between finance company indirect customer rate and
finance company dealer participation rate (+.901) and
the correlation between commercial bank indirect cus-
tomer rate and commercial bank dealer participation
rate (+.779). Thus it appears that retail dealers, through
markup on their interest rates, account for most of the
interstate variance of indirect customer rates.
A second set of correlations are also to be expected
even though the rates are not related by definition.
These are the correlations which occur between two
rates that are set by the same decision making units.
Commercial banks establish both a direct customer rate
and an indirect net rate, and the correlation between
these is +.591. Similarly, dealers exercise substantial
influence in establishing both the commercial bank
dealer participation rate and the finance company dealer
participation rate. The correlation between these two'
rates is +.777. It appears, then, that common causal
forces underly each pair in this second set of correla-
tions. Moreover, the high correlation between the two
dealer rates must certainly contribute substantially to
tire +.626 correlation between the finance company
dealer participation rate and the commercial bank
indirect customer rate, the +.673 correlation between
tire commercial bank dealer participation rate and the
finance company indirect customer rate, and the +.693
correlation between the commercial bank indirect cus-
tomer rate and the finance company indirect customer
rate.
115
EXHIBIT 7-2
Correlation Matrix of New Auto Credit Interest Rates (APR's) Across 39 States
Commer-
cial Bank
Direct
Rate
Commercial
Bank
Indirect
Customer
Rate
Finance
Company
Indirect
Customer
Rate
Commer-
cial Bank
Dealer
Participa-
tion Rate
Finance
Company
Dealer
Participa-
tion Rate
Commer-
cial Bank
Indirect
Net
Rate i
Finance
Company
Indirect
Net |
Rate
Credit
Union
Direct
Rate
Commercial Bank
Direct Rate
1.000
.532**
.211
.192
.038
.591**
.409**
.272
Commercial Bank
Indirect Customer
Rate
1.000
.693**
.779**
.626**
.553**
.371*
.152
Finance Company
Indirect Customer
Rate
1.000
.673**
.901**
.206
.539**
.156
Commercial Bank
Dealer Participation
Rate
!
!
1.000
.777**
-.091
.032
.155
Finance Company
Dealer Participation
Rate
I
1.000
-.038
.120
.156
Commercial Bank
Indirect Net Rate
1.000
.546**
.034
Finance Company
Indirect Net Rate
1.000
.063
Credit Union
Direct Rate
1
1.000
'Significant at the 5 percent level
"Significant at the 1 percent level
Note that the Commercial Bank Dealer Participation plus Commercial Bank Indirect Net Rate equals the Commercial Bank Indirect
Customer Rate and that the Finance Company Dealer Participation plus the Finance Company Indirect Net Rate equals the Finance
Company Indirect Customer Rate.
States omitted because of incomplete data: Alaska, Delaware, District of Columbia, Hawaii, Kansas, Montana, New Hampshire, North
Dakota, Rhode Island, South Dakota, Vermont, and Wyoming.
Finally, there is a third set of pairings which generate
high positive coefficients but which have no obvious
reason to be highly correlated. For example, the finance
company indirect net rate and the commercial bank
direct rate are significantly correlated (+.409). The
correlation between finance company indirect net rate
and the commercial bank indirect net rate (+.546), too,
is significant. Though not significant, the commercial
bank dealer participation rate is somewhat correlated
with the commercial bank direct rate, suggesting that
where the commercial bank direct rate is relatively high
and demand shifts from commercial banks to retailers,
retailers may be able to charge higher markups on their
rates than they otherwise would. Since most of these
otherwise unexplained relationships concern the com-
mercial bank direct rate for new auto credit, it appears
from Exhibit 7-2 that if any one of the interest rates for
new auto credit could be considered a “pivotal” or
“focal point” rate, it would be the commercial bank
direct rate. Knowledge of the determinants of the
commercial bank direct rate would probably contribute
to a better understanding of the commercial bank
116
indirect net rate, the finance company indirect net rate,
and, perhaps, the commercial bank and finance company
dealer participation rates. Since commercial bank and
finance company indirect customer rates are comprised
of these latter four rates, an understanding of them
would follow automatically.
Credit union rates for new auto credit are not
significantly correlated with any other rates, but even
here, the credit union direct rate is most closely
associated with the commercial bank direct rate.
Commercial bank direct new auto credit. The Com-
mission staff analysis of interstate variations in the
average of rates of charge for commercial bank direct
new auto credit shows that the average rate is positively
associated with bank concentration (the share of direct
extensions accounted for by the four banks with the
largest extensions of direct new auto credit), the average
interest rate paid on commercial bank time deposits (the
surrogate for the cost of capital) and the type of banking
structure permitted within the state. Other variables
tested, but not sufficiently correlated to be statistically
significant were bank salary expenses per employee,
bank delinquency rates, unemployment rates, rate ceil-
ings, bank growth rate, volume of bank nonconsumer
credit business, and volume of bank nonauto credit
business. The lack of significance for a legal rate ceiling
variable is suggested by Exhibit 6-2, which shows that in
most states rates typically charged on this class of loan
were well below the ceiling rate. Among those few states
where rate ceilings can be said to have a definite
restrictive effect on price, Arkansas, which has relatively
low bank concentration (16 percent), has a rate ceiling
of 30 percent (APR) and an average typical reported rate
of 10.12 percent. It appears that a significant number of
new car bank loans there are made at illegal rates unless
Arkansas law requires or permits a method of computing
charges different from the actuarial method.
The variable having the greatest statistical significance
is the average interest rate paid on commercial bank time
deposits. If the average time deposit rate were 5 percent
in one state and 6 percent in another, that differential is
associated with a variation of not quite half of 1 percent
(0.454 percent) in the average APR charged on direct
auto loans by banks (holding the concentration ratio
constant). 6
The other highly significant variable is the bank
concentration ratio. On average, a 10 percentage point
difference in bank concentration (say, 50 percent versus
60 percent) is associated with a 0.1 percent variation in
the APR (0.098 percent) on direct auto loans. This
relationship between observed APR’s and expected
APR’s on direct new auto loans by commercial banks at
various levels of market concentration, with other
factors held constant, is illustrated in Exhibit 7-3. Actual
observed APR’s do not correspond exactly to the
predicted APR’s because the observed data reflect
uncontrolled unidentified factors assumed to be random.
Examination of some states that appear to deviate from
the norm reveals some plausible explanations for such
behavior. For example, the low APR in Maryland
probably reflects competition from banks and Federal
credit unions in the District of Columbia. In states where
rates are higher than predicted, the result may reflect
unexplained cost factors or a lesser degree of competi-
tion than expected.
Despite such deviations, there is, on average, an
observable association between the APR on direct new
auto loans and bank concentration that is unlikely to
have occurred by chance. Responsiveness of the APR to
differences in the bank concentration ratio among the
states is not great, but the large differences in concentra-
tion ratios among the states support the hypothesis that
market power, as evidenced by market concentration
among commercial banks, is associated with substan-
tially higher average rates of charge for new car loans.
Analysis of the data reveals a high correlation
between bank concentration and branch banking priv-
ileges (Exhibit 7-4). Replacement of the concentration
ratio in the analysis with variables representing the
presence of limited or statewide branching shows that,
with differences in commercial bank time deposit rates
held constant, a state with statewide branching privileges
has, on average, APR’s averaging 0.41 percentage points
higher than those in unit banking states. Although the
nature of the relation of concentration and branch
banking to rates and availability of credit is detailed
more fully later, the existence of market power does not
always result in the exercise of that power. For example,
banks in Delaware show relatively high concentration
(89 percent) but the average reported ratio is relatively
low, 9.98 percent (Exhibit 7-4). Nor do statewide
branching privileges always result in extremely high bank
concentration. California, which permits statewide
branching, has only 37 percent concentration and an
average reported APR on direct new auto loans of 9.23
percent. It is apparent that the presence of a large
number of banks (excluding branches) and credit unions
in California greatly stimulates banking competition. Yet
these cases are exceptions to the significant average
relationships of concentration and status of statewide
branching to the APR’s among all of the states included
in the analysis.
The commercial bank direct rate is probably the
single most important rate in the new auto credit
market, because it is the “pivotal” rate, much like the
prime rate functions in the commercial loan market.
Other new auto credit rates appear keyed to it. In
addition to being heavily influenced by the commercial
117
EXHIBIT 7-3
Bank Concentration and the Rate of Charge for Commercial Bank Direct New Automobile Loans
APR
Notei Dots represent observed average prices. The predicted
price is based on the following regression equation j
CBDP *= 5,73 + 0.0098 CRDB + 2,49 LTDI,
_ (. 0034 ) (. 77 )
where CRBD is bank concentration in the direct loan market
and LTDI is the logarithm of the average time deposit rate
for commercial banks ; LTDI is held constant at its average
value of 1,66, T ratios are below the regression coefficients.
The following states were omitted from the regression analysis
because of incomplete dataj Alaska, Delaware, District of
Columbia, Hawaii, Kansas, Montana, New Hampshire, North Dakota,
Rhode Island, South Dakota, Vermont, Wyoming, Observed values
are plotted when available.
118
Exhibit 7-4
Observed Rates Charged for Direct New Auto Credit at Commercial Banks in States with Highest
and Lowest Bank Concentration
Observed
High Concentration States
Concentration Ratio
Type of Branching
(a> Rate
Alaska
89.9
SB
11.38
Delaware.
86.0
SB
9.98
Idaho
86.8
SB
10.42
Nevada
84.7
SB
10.97
Rhode Island
71.2
SB
10-97
Washington
66.6
SB
10.55
Arizona
64.6
SB
11.16
Oregon
62.9
SB
10.43
South Carolina
55.8
SB
10.53
North Carolina
51.0
SB
10.66
Average
72.0
Average 10.71
Low Concentration States
Montana
10.6
LB
9.86
Indiana
9.7
LB
10.21
Wisconsin
8.8
LB
9,28
Kansas
7.6
UB
9.70
Oklahoma
7.5
UB
10.67
Iowa
6.1
UB
9.82
Minnesota
4.6
UB
10.10
Texas
2.8
UB
10,11
Illinois
2.6
UB
9.37
Average
6.7
Average 9.90
(at SB = Statewide branch banking
LB = Limited branch banking
UB = Unit banking
Source: National Commission on Consumer Finance Survey of Consumer Credit Volume, Second Calendar Quarter, 1971, and
Consumer Credit Outstanding, June 30, 1971.
Note to Exhibit 7-4
Statewide Branch Banking States
Limited Branch Banking States
Unit Banking States
Alaska
Alabama
Arkansas
Arizona
Georgia
Colorado
California
Indiana
Florida
.. Connecticut
Kentucky
Illinois
Delaware
Louisiana
Iowa
Hawaii
Massachusetts
Kansas
Idaho
Michigan
Minnesota
Maine
Mississippi
Missouri
Maryland
New Hampshire
Montana
Nevada
New Jersey
Nebraska
North Carolina
New Mexico
North Dakota
Oregon
New York
Oklahoma
Rhode Island
Ohio
Texas
South Carolina
Pennsylvania
West Virginia
Utah
South Dakota
Wyoming
Vermont
Tennessee
Virginia
Wisconsin
Washington
District of Columbia
496-072 0 - 73 - 10
119
bank direct rate, the other major new auto credit
rates-particularly the finance company net rate and the
finance company and commercial bank dealer participa-
tion rates— are in part determined by risk costs and size
and efficiency of retail dealers. In some states— those
with low rate ceilings— the finance company indirect
customer rate, dealer participation rate, and net rate are
largely functions of the legal rate ceiling. 7
Availability of new auto credit
Since the preceding discussion of new automobile
credit rates indicated the likelihood of market imperfec-
tions in some states, the new automobile credit market
cannot be generally characterized as having full avail-
ability. To assess the relative availability of new auto-
mobile credit, relationships between the amount of
credit actually extended per family within each state and
factors explaining the variation in these amounts are
examined. In new automobile credit markets the pri-
mary factors that appear to affect availability are legal
rate ceilings and noncompetitive behavior of some credit
suppliers. The latter is suggested by the relationship
between market concentration and rates paid for credit
in some market segments. When bank concentration in
the automobile credit market is high, for instance, the
associated higher rates charged for' credit result in less
credit. However, analysis of the market structure sug-
gests that the availability of auto credit from each of the
market segments does not follow the same pattern.
When the amount of direct automobile loans supplied by
banks is low (because of demand), the amount supplied
by dealer financing is higher (also because of demand).
Consumers who typically borrow directly from banks
(or credit unions) can be characterized as less cash-
constrained, less risky and more sensitive to rates
charged for credit than those who generally finance
through automobile dealers. In economic terminology,
bank customers for new auto direct credit appear to
have- a higher price elasticity of credit demand. As rates
charged for credit increase, the amount of credit
demanded decreases, A 10 percent rise in the average
APR on direct auto loans at banks can be expected to
reduce the dollar amount of bank auto loans sought by
29 percent while the average APR’s for dealer financing
stay the same. Of consumers who choose not to borrow
from banks when rates are higher, one-half can be
expected to buy on cash terms while the other half will
rely on dealer financing. Since the average APR in dealer
financing is generally higher than the average APR in
direct bank financing, the demand shift to retailers must
be explained by such nonrate considerations as (a) con-
venience of dealer financing; (b) more favorable non-
price credit terms from dealers (for example, longer
maturities and lower downpayment); (c) less credit
shopping when there is little variation in rates charged
by alternative sources'; and (d) possibility of nonprice
credit rationing by banks. The last factor implies that
banks may find it profitable to encourage a shift to
dealer financing, some of which is supplied indirectly by
banks. Although the banks’ net rate on purchased paper
may be somewhat less than on direct loans, some
portion of the risk may be shifted to dealers through
recourse arrangements, and some direct loan costs, such
as advertising, are substantially lower when paper is
purchased from auto dealers. For these reasons, a higher
level of dealer financing co-exists with lower availability
of direct bank credit. Also, shifts by some consumers to
cash buying implies that total credit availability is
somewhat less when the higher rates result from non-
competitive behavior on the part of the suppliers, There
is some evidence to support this, as indicated earlier with
regard to rates of charge, and it applies equally to
availability.
Commercial bank direct loans. The amounts of
commercial bank direct new automobile credit supplied
are related significantly to branch banking structure and
concentration.
Commercial banks in states permitting statewide
branching on average supply approximately $18 per
thousand households less direct auto credit than banks
in unit banking states, other things being equal. Simi-
larly, limited branching states supply, on average, ap-
proximately $11 per thousand households less than
banks in unit banking states. Since the average amount
supplied by banks in the 39 states analyzed was
approximately $30 per thousand households, branching
structure would appear to have a substantial effect The
lesser amount of direct bank auto credit per thousand
households can partly be traced., to differences in bank
concentration ratios, particularly statewide branching
states where concentration ratios are higher (the simple
correlation being .85),
The higher rates associated with branch banking and
bank concentration result in lower use of direct auto
credit seemingly because of negative reaction by con-
sumers to the higher rates. But, whether or not rate
sensitivity causes the shift, the general pattern of
association between bank concentration and credit
availability in the bank new auto credit market is
unchanged. As shown in Exhibit 7-5, high levels of bank
concentration are generally associated with a lower
direct bank loan share of the total automobile credit
market. This implies that dealer financing is correspond-
ingly higher.
The association of higher concentration ratios with
higher APR’s does not prove the exercise of market
power, since the same set of data could be consistent
120
EXHIBIT 7-5
Bank Concentration and Market Share: Dollar Volume of Direct Automobile Loans
as a Percent of Total Automobile Credit Extended
Market Share,
Bank Concentration, Percent (CRDB)
Note: The estimated market share is based on the
following regression equation:
EMS = 38.69 - .236 CRDB
(.052)
121
with other hypotheses. Indeed, statewide concentration
ratios, whatever their level, fail to reflect accurately the
realities of individual geographic markets for consumer
credit within the state.
Commercial bank indirect financing at auto dealers.
As suggested earlier, credit availability in this segment of
the market is positively associated with bank concentra-
tion, indicating a shift in demand from bank direct loan
customers to dealer financing in response to narrowed
rate differentials between the two markets. Legal rate
ceilings also significantly influence availability in the
bank new auto indirect loan market. The size of the
implied curtailment, 16 cents per household for each
percentage point difference in the ceiling APR, is not
large. As expected, the growth of banks and a higher
level of real income are also associated with higher
availability, while a higher cost of capital has a negative
effect.
Finance company credit at auto dealers. It appears
that the supply of automobile credit from finance
companies is not associated with bank concentration.
Any shift from the direct bank sector is directed
primarily into the cash market and the bank indirect
credit market at dealers. This is not surprising in view of
the risk gradation among the sectors of the automobile
credit market. Since finance companies tend to accept
higher risk contracts that carry higher rates, the sales
finance contracts of consumers who shift from the direct
bank market to dealer financing will gravitate toward the
bank indirect sector rather than the finance company
indirect sector.
Bank concentration and sources of auto financing.
Overall implications of the foregoing findings are illus-
trated by examining the different sources of automobile
financing and the average rates charged for credit in two
groups of states with the highest and lowest bank
concentration ratios. 8 Exhibit 7-6 shows, for each
group, the average percent of automobile sales financed
at the various credit sources and the average rate for
credit, based on observed values. In the low concentra-
EXHIBIT 7-6
Bank Concentration and the Source and Rates Charged for Automobile Credit in 10 High and Low
Concentration States
Source of Financing
High Concentration States*
Low Concentration States*
Average Percent
of Auto Sales
Financed at
Source
Average Rate of
Charge for
Credit (APR)
Average Percent
of Auto Sales
Financed at
Sou rce
Averge Rate of
Charge for
Credit (APR)
Direct Loans
Banks
15.84
10.73
27.37
9.97
Credit Unions
10.68
11.36
10.07
11.23
26.52
37.44
Dealer Financing
Banks
25.32
12.73
15.58
12.08
Finance Company
16.20
12.35
11.54
12.33
41.52
27.12
Cash Sales and Other**
31.96
35.44
Total
100.00
100.00
*High concentration states (average concentration ratio of 64 percent): Arizona, Nevada, Oregon, South Carolina, Washington
Low concentration states (average concentration ratio of 6 percent): Illinois, Iowa, Montana, Oklahoma, Texas
**"Other" includes dealer-held finance contracts and all miscellaneous sources.
The relationships shown in this Exhibit and in Exhibits 7-10, 7-1 1 and 7-12 are supported by significantly regression coefficients
in staff econometric studies.
122
tion group (states with an average concentration ratio of
6 percent), an average of 27,37 percent of all auto sales
are financed directly at banks at an average APR of 9.97
percent for direct loans. In the high concentration group
(states with an average concentration ratio of 64
percent), only 15.84 percent of all auto sales are
financed directly at banks, and the average APR is 10.73
percent for direct loans. The pattern is reversed for
dealer financing. In the low concentration group, only
27.12 percent of sales are financed through dealers: in
the high concentration group 41.52 percent of sales are
so financed. Within the dealer financing market, the
larger change occurs in the banks’ share, with a higher
rate for bank credit in the high concentration group. The
pattern of credit union financing is not significantly
different in the two groups.
This illustration discloses the significant association
between bank concentration and rates and sources of
automobile financing. But not all states follow the same
pattern, nor do all states within each of the illustrative
groups.
Conclusions on New Auto Credit Market
Average rates charged for new automobile credit at
banks and automobile dealers, and associated distribu-
tion of automobile financing at alternative credit
sources, are related significantly to the cost of bank
capital, bank concentration, and banking structure. High
cost of capital and high levels of bank concentration,
most often associated with statewide branch banking,
are generally associated with higher average rates for
direct bank new auto loans and less automobile financ-
ing of that type. More financing is obtained through
automobile dealers, and at still higher rates, because
dealers charge higher rates in those states with less rate
competition from bank direct loans, However, credit
union loan volume and rates seem to be unaffected by
the behavior of the other market sectors. Although some
interstate variations in the pattern and cost of auto-
mobile financing are the result of restrictive rate
ceilings in a few states, the major differences are
associated with bank concentration. 9 Bank operating
costs may be partly responsible for higher rates of
charge, but the staff research suggests they are not the
primary factor.
These observations suggest that noncompetitive ele-
ments in some states are associated with high bank
concentration. However, market concentration does not
inevitably result in noncompetitive behavior, nor does
branch banking inevitably result in high bank concentra-
tion. After review of other credit markets, the Commis-
sion will offer recommendations to improve the com-
petitive environment of all consumer credit markets.
The Other Consumer Goods Credit Market
The second major consumer credit market consists of
credit extended for the purchase of consumer durable
goods other than automobiles, mobile homes, boats,
aircraft, and recreational vehicles. Household goods and
apparel are major components of this market. Major
suppliers of this kind of credit are banks, credit unions,
finance companies, and retail stores.
Market Structure
Credit purchase of Other Consumer Goods (OCG) can
be financed by one of two forms of instalment credit:
(1) closed end credit, wherein the contract maturity is
fixed at the time credit is granted, or (2) open end or
revolving credit, wherein a series of credit purchases may
be charged to a single account on which the consumer
must pay a part of the periodic balance. The credit
buyer who seeks instalment credit has several alterna-
tives'. (1) direct loans from banks; (2) direct loans from
credit unions; and (3) instalment sales financing through
retail stores. 10 Retail sales financing, in turn, may be
supplied directly by retailers or indirectly by banks and
finance companies that purchase sales finance contracts
from retailers. The amount of credit supplied at the
national level in each of these categories during the
second quarter of 1971 is shown in Exhibit 7-7. The
total of $9,128 billion from the Commission survey
represents approximately $134 per family, with 62
percent of this total supplied in the form of revolving
credit. Within the closed end instalment credit sector,
retailers clearly represent the largest direct source, with
46 percent in that category.
Bank and credit union direct loans represent less than
20 percent of total OCG instalment credit. Over 80
percent is arranged through retailers. In addition, re-
tailers supply over one-half of revolving credit exten-
sions. Retail-originated financing predominates for two
major reasons: convenience of credit, and some risk
segmentation of the market, Because OCG credit is
regarded primarily as a convenience, factors such as
location of credit source and ease of accessibility are
primary considerations. Although the finance rate is
higher than rates for new car financing, the dollar
amount of finance charges is relatively small because of
the smaller average cost of purchases. Consequently,
consumers are more interested in convenience than in
credit price which leads them to retailers. Opportunities
to shop for credit at banks and credit unions may be
limited to the better credit risks who want to finance
relatively large purchases. Even the better credit risks do
not always seek direct loans at banks and credit unions
because the convenience of retailer financing or bank
123
EXHIBIT 7-7
Other Consumer Goods Instalment Credit Extensions by Major Sources, Second Quarter, 1971
Total Extensions,
All States
Percent of
(in $ millions)
Total
Closed-end Credit
Retail direct extensions
$1,584
46.1
Bank direct loans
398
11.6
Credit union loans
280
8.2
Bank indirect financing
through retailers
595
17.3
Finance company indirect
financing through retailers
576
16.8
Total Instalment Credit
$3,433
100.0
Revolving Credit
Retail revolving credit
$3,224
56.6
Bank revolving credit
2,471
43.4
Total Revolving Credit
$5,695
100.0
Total Other Consumer Goods Credit
$9,128
100.0
Source: National Commission on Consumer Finance Survey of Consumer Credit Volume, Second Calendar Quarter, 1971, and
Consumer Credit Outstanding, June 30, 1971. Data from the Board of Governors of the Federal Reserve System show
total extensions (not seasonally adjusted) of $10,049 million.
revolving credit may outweight the cost advantages of
direct loans, especially for smaller purchases. 1 1
The prevalent use of revolving credit is also related
primarily to convenience. Consumers with high incomes
or high levels of liquid assets may use credit cards
primarily for the convenience of repaying obligations
with little or no finance charges. Besides the convenience
of purchasing goods under a line of credit, revolving
credit is attractive for some consumers because its lack
of fixed monthly payment requirements (beyond a
minimum amount) permits consumers to modify pay-
ment patterns to meet their own needs.
. Analyses of OCG credit focused on the three major
forms of OCG financing: (a) revolving credit, (b) direct
loans from banks and credit unions and (c) retailer-
originated closed end instalment financing for which the
following general observations are presented.
Finance Rates and Availability
Revolving Credit. The supply of revolving credit from
banks and retailers is generally responsive to the demand
for revolving credit, with credit rationing unlikely except
on the bases of rate and credit risk. Thus, most
creditworthy borrowers are likely to be able to obtain
credit cards. This is especially true in the case of retail
revolving credit since the primary impetus to the
granting of retail credit via credit cards is the promotion
of retail sales in competition with other retailers who
also offer credit. From the consumers’ viewpoint,
demand for revolving credit is higher from younger
families and increases with higher incomes. In addition,
interstate variations in revolving credit usage are posi-
tively related to marriage rates within the states and the
level of OCG sales.
Since the finance rates on bank and retail revolving
credit are typically near 18 percent and show little
inter-state variation, it is difficult to assess the relation-
ship between rates and availability. Moreover, the
potential effect of restrictive rate ceilings is difficult to
evaluate empirically because of the possibility that
finance charges may be hidden in the price of the goods
sold. Thus, cash buyers (some of whom may have been
unable to obtain credit) and better credit risks may
subsidize credit extensions to higher risk consumers to
an extent such that there is little effect on overall
availability. However, Exhibit 7-8, which shows the level
of revolving credit usage for a subset of 1 i states with
124
EXHIBIT 7-8
Revolving Credit Rates and Availability: A Subset of States with Below-Average Rates
State
Bank and Retail
Revolving Credit
($ per Family)
Average Bank APR
on $100 - Revolving
Credit Card Balance
Average Retail APR
on Revolving Credit
(percent)
(percent)
Arizona
$124
15.96
18.00
Arkansas.
59
D
10.08
Iowa
49
12.09
18.00
Kansas
63
18.00
14.92
Minnesota
87
NR
14.11
New Jersey . . ;
59
12.63
18.00
Oregon
84
15.00
18.00
Pennsylvania
66
15.00
15.12
Washington
107
12.00
12.00
West Virginia
51
15.84
18.00
Wisconsin
71
15.91
12.00
Single average for group
$74.5
14 71 ( b)
15.29
Average for all States* 0 )
$80
1 7.20 (c)
17.24
D = unavailable because of disclosure restrictions
NR = no reported data
* a ) States not included because of data disclosure restrictions: Alaska, Montana, District of Columbia
^ Arkansas and Minnesota excluded
* c ) States not Included because of data disclosure restrictions: Alaska, Arkansas, Hawaii, Minnesota, Montana,
North Dakota, South Dakota, District of Columbia
Source: National Commission on Consumer Finance Survey of Consumer Credit Volume, Second Calendar Quarter,
1971, and Consumer Credit Outstanding, June 30, 1971,
below-average rates, indicates that lower rates of charge
may be related to lower availability.
Direct Loans from Banks and Credit Unions. Data on
finance rates on direct OCG loans from financial
institutions are not available because OCG loans are
often recorded as personal loans, rather than being
classified separately. In this case, however, it is reason-
able to assume that bank rates would be approximately
equal to the rate on a comparable personal loan.
Similarly, credit union OCG loans would be expected to
yield approximately 12 percent, the predominant rate of
state and Federally chartered credit unions. Although
the effects of creditors’ remedies, rate ceilings and
competition could not be determined in the absence of
rate data, it is likely that conclusions reached for the
bank personal loan market would apply here as well.
The staffs interstate analysis indicates that demand
for direct OCG credit, relative to OCG sales, is positively
associated with higher income, higher marriage rates and
higher rates of charge on retail-originated instalment
financing. The data also suggest that the supply of credit
is restricted by restrictions or prohibitions against
garnishment and wage assignments. The data also show
that lower credit availability is associated with high
levels of bank concentration, although credit union
concentration is unrelated. The extent of this association
is illustrated in Exhibit 7-9 which shows the levels of
direct OCG loan extensions relative to sales and bank
concentration for two subsamples of states with high
and low credit availability. Although this simple com-
parison neglects other demand and supply factors, the
staffs econometric analysis shows that the negative
relationship between concentration and supply is statis-
tically significant even when other factors are taken into
consideration. Thus, these findings are consistent with
the analysis of the new automobile direct credit market.
Retail-originated Closed End Instalment Credit. The
analyses of finance rates on retail instalment credit
involved the examination of three supply components:
retailers, commercial banks and finance companies. The
125
EXHIBIT 7-9
Market Concentration and the Percent of Other Consumer Goods Sales Financed Directly at
Banks and Credit Unions
Percent of OCG Sales Financed Directly at Banks and Credit
Unions
Average of 12 States
with Highest Percent
of Direct Loan
Financing* 8 *
Average of 12 States
with Lowest Percent
of Direct Loan
Financing* 1 ^
8.4 %
3.3 %
Bank Concentration* 8 * 40.3% 59.5%
* a * States Included: Utah, New Mexico, Idaho, Colorado, Michigan, Alabama, Nevada, Iowa, North Carolina, Virginia,
Texas, Florida
*k* States included: Maryland, Missouri, Hawaii, Mississippi, Vermont, Washington, Pennsylvania, California, Arizona,
Delaware, New Jersey, New York
States droppad from consideration because of disclosure restrictions or questionable data: Alaska, Arkansas,
Kansas, Kentucky, Louisiana, Maine, Montana, North Carolina, North Dakota, Oklahoma, Rhode Island,
South Dakota, West Virginia, Wyoming, District of Columbia
* c * Four-firm concentration ratio (percent) for commercial bank and mutual savings bank direct OCG loans
Source: National Commission on Consumer Finance Survey of Consumer Credit Volume, Second Calendar Quarter,
1971, and Consumer Credit Outstanding, June 30, 1971.
analyses of finance rates on sales finance contracts
originated and held by retailers indicate that interstate
variations in rates are not highly correlated with rate
ceilings or creditors’ remedies. Although operating cost
data were not available for analysis, there is some
indication that rate levels are positively related to the
interest rate on bank time deposits, which is a surrogate
measure of the cost of funds. In addition, there is some
indication that rates on direct retail credit are somewhat
lower when concentration among the bank and finance
company suppliers of retail credit is high. This may
indicate some competition and efficiencies of scale for
the bank and finance company suppliers of retail credit.
However, the results are largely inconclusive since these
explanatory factors account for only 20 percent of the
interstate variations in rates. It is possible that the high
unexplained variation is a result of finance charges being
hidden in the price of goods when rate ceilings are low
or when other market imperfections exist.
The analyses of finance rates on retail credit supplied
indirectly by finance companies indicate that approxi-
mately 46 percent of the interstate variation in rates is
due to legal rate celings, It is also apparent that higher
levels of finance company concentration tend to be
associated with a lower dealer APR participation rate
(the portion of the customer APR retained by the
retailer), although there is no correlation with the net
finance company rate. This may indicate that large sales
finance companies either use market power to increase
their share of the finance charge or limit their acceptable
credit risk to a greater extent than the smaller firms,
thereby reducing the risk (and dealer participation) to
retailers. There is also some indication that the abolition
of holder in due course defenses and waiver of defenses
tend to result in lower finance rates to the customer.
Although this result appears to be somewhat contra-
dictory, it is possible that finance companies impose
more stringent quality standards and charge less when
such creditors’ remedies are abolished. This explanation
is reinforced by the fact that rate ceilings in some states
prevent any substantial increases in rates when such
creditors’ remedies are abolished.
The negative relationship between finance rates and
the abolition of the aforementioned creditors’ remedies
is also found in the case of retail credit supplied
indirectly by commercial banks. In this case, however,
there is little indication that legal rate ceilings have an
overall restrictive effect on finance rates. Thus, it is quite
possible that banks tend to purchase the higher quality
sales finance contracts. As expected, finance rates also
appear to be positively associated with bank operating
costs and cost of funds. In addition, higher levels of
bank growth, an indication of an environment conducive
to competition, is associated with lower rates. However,
higher levels of bank concentration are associated with
higher rates, suggesting that there is a range of com-
126
petitive and noncompetitive conditions among the
states.
In the analysis of retail-originated credit, the indi-
vidual amounts of OCG credit supplied by retailers,
banks, and finance companies were grouped as one
collective source. The econometric analyses indicate that
lower levels of retail sales financing, relative to total
OCG sales, are associated with higher market concentra-
tion in the retailer and finance company sectors. As
illustrated in Exhibit 7-10, the average level of retailer
concentration (51 percent) in a sample of 12 states with
the highest average percentage of retail sales financing is
substantially lower than the average level of 67 percent
for retailer concentration in a sample of states with the
lowest average percentage of retail sales financing. A
similar correlation is seen in the case of finance company
concentration. The econometric analyses indicate that
these relationships are statistically significant even when
credit demand factors such as aggregate income, urban-
ization and age composition of the population are taken
into consideration. The econometric analyses indicate
that high levels of market concentration among the bank
suppliers of indirect credit are positively associated with
indication is present in the simple comparisons of
Exhibit 7-10. This contradiction with the apparent
effects of retailer and finance company concentration,
however, is consistent with observations of credit avail-
ability in the new automobile credit market, where high
levels of bank concentration are associated with lower
levels of direct loans at banks but positively associated
with higher levels of financing at automobile dealers.
Again, these observations are consistent with the ex-
pected behavior of firms in imperfectly competitive
markets.
The econometric analyses also indicate that the
abolition of holder in due course defenses and waiver of
defenses results in lower credit availability from finance
companies and retailers directly, although the supply of
indirect bank credit is not affected. Of the seven states
that have abolished both defenses, Hawaii, Massa-
chusetts, New York and Vermont are in the group of
states with the lowest average availability; Utah and
Washington are in the group of states with average
availability (Arkansas was deleted from the analysis
because of questionable data). Although the apparent
restrictive effect on retailer-held credit is paradoxical
higher levels of retail financing, although
no such
since these remedies are
not applicable to direct sup-
EXHIBIT 7-10
Market Concentration and the Percent of Total Other Consumer Goods Sales Financed
Through Retailers
Average of 12 States
Average of 12 States
with Highest Percent
with Lowest Percent
of Retailer Financing* 3 *
of Retailer Financing* 13 *
Percent of Total OCG Sales Financed at Retailers
20.8
10.8
Retailer Concentration* 0 *
51.3
67.1
Ban k 1 nd i rect Conce ntratio n * 0 *
46.3
47.4
Finance Company Concentration* 0 *
54.3
63.5
Rate Ceiling for $800, 24 months retail sales financing . . ,
20.15* d *
20.14* e *
* a * States included: Missouri, Nevada, Mississippi, Oregon, Indiana, Virginia, Iowa, Tennessee, South Carolina, Georgia, Minnesota,
Texas ___
*bl States included: Arizona, Hawaii, Vermont, Delaware, Colorado, Illinois, California, New York, Connecticut, Massachusetts,
New Jersey, New Hampshire
States dropped from consideration because of disclosure restrictions or questionable data: Alaska, Arkansas, Kansas, Kentucky,
Louisiana, Maine, Montana, North Carolina, North Dakota, Oklahoma, Rhode Island, South Dakota, West Virginia, Wyoming,
District of Columbia
* c * Four-firm concentration ratio (percent!
* d * Six states with no legal rate ceiling not included in the average
* E * Three states with no legal rate ceiling not included in the average
Source: National Commission on Consumer Finance Survey of Consumer Credit Volume, Second Calendar Quarter, 1971, and Consumer
Credit Outstanding, June 30, 1971.
127
pliers of credit, it is quite possible that any restrictive
effect arises from the inability of retailers to sell the
lower quality sales finance contracts and their unwilling-
ness or inability to hold the contracts themselves. This
proposition is explored in greater detail in the discussion
of creditors’ remedies in Chapter 3.
Conclusions on the OCG Credit Market
The Commission’s studies indicate the presence of
some credit rationing in the bank direct loan market and
in the retail-originated instalment credit market supplied
by retailers and finance companies. In view of the overall
importance of retailer-supplied credit, the credit ration-
ing is more substantial in that market segment. Since
legal rate ceilings in some states have a restrictive effect
on the finance rates on finance company credit, and
possibly on that of retailer-held credit, the credit
rationing is primarily of a nonprice nature. That is,
suppliers apparently restrict supply to accommodate the
better credit risks rather than increase finance rates to
serve higher credit risks. In addition, there is some
indication that reduced availability of OCG credit is
associated with the abolition of creditors’ remedies.
The Personal Loan Market
The Commission’s study of the personal loan market
involved the analysis of rates of charge and availability
of personal loans from three main sources: banks,
finance companies and credit unions. As with the other
credit markets, this discussion begins with an analysis of
market structure and then proceeds to review the
research findings on the price and availability of personal
loans.
Market Structure
Since the personal loan market by definition consists
entirely of direct cash lending, the analysis of market
structure is simplified by the absence of indirect credit
and the complications associated with retailer-
established credit prices. Thus, there is no opportunity
for the price of credit to be included in the price of
goods sold, although some portion of the finance charge
may be included in the premium for credit insurance.
The potential borrower has three main alternative
sources: banks, credit unions (if he or she is a member)
and finance companies.
It is generally acknowledged that there is some
gradation in the risk classification of borrowers typically
served by the various institutional sources. Since rates
paid for credit should be related to the credit risk of the
borrower, some measure of risk gradation is obtained by
a preliminary review of the typical rates at various
sources. Based on the average of state responses for the
institutional average price of personal loan credit within
each state, the following institutional ranking of rates
(from low to high) is observed:
Average of State Responses 1 2
Credit Unions
11.76%
(All personal loans)
Mutual Savings
12.44%
($1000, 12 months
Banks
unsecured instalment
loans)
Commercial Banks
13.04%
($1000, 12 months
unsecured instalment
loans)
Finance Companies
25.88%
(All personal loans;
average of state-
average loan sizes
= $979)
Although variations in average loan size distort this
comparison to some extent it is reasonable to assume
that borrowers at finance companies are likely to be in a
higher risk category than borrowers at the other institu-
tions and will pay a correspondingly higher rate for the
credit service. Risk gradations may be explained by two
basic factors: legal constraints and industry practice. The
primary legal constraint placed on banks and credit
unions in some states is the legal rate ceiling. It is easy to
see that a low rate ceiling will limit the number of
borrowers who qualify (on a risk basis) for credit at that
price. Unqualified borrowers must then seek alternative
sources. To put the matter in historical perspective, it is
recalled that state personal loan legislation has generally
been enacted to set higher rate ceilings for certain
institutions, notably finance companies, and to supervise
closely their lending activities. Thus, finance companies
can generally serve some borrowers who cannot be
served under the rate ceilings governing other institu-
tional sources of credit. Potential borrowers who cannot
be served by finance companies must either forego credit
or seek a source which provides credit at even higher
prices— pawn shops and illegal lenders, for example.
Thus, it is clear that diverse legal rate ceilings tend to
promote market segmentation on the basis of risk. It is
also clear that inter-institutional differences in the kinds
of permissible creditors’ remedies will promote risk
gradation in the same manner.
The “industry practice” explanation for risk grada-
tion implies that some credit institutions may find it
convenient to shape their operations to attract bor-
rowers within a portion of the risk spectrum of all
borrowers. According to this premise, banks consider
themselves to be low-rate lenders, while finance com-
panies cover the upper spectrum of credit rates. The
Commission finds some support for this viewpoint in the
128
comparison of bank personal loan rate ceilings and the
corresponding reported rates of charge. In states where
the bank rate ceiling is relatively high or nonexistent, the
average reported bank rate is still in many cases
considerably below the average rate at finance com-
panies. In this case it can be inferred that accepted bank
customers are better credit risks than those borrowing at
finance companies. While such specialization of opera-
tions may result in some cost efficiencies, one other
result of such behavior is a reduction of intersource
competition between low rate and higher-rate lenders.
However, this latter result is less serious if there exists
substantial cost efficiencies from such behavior and if
there is active intrasource competition.
It should be noted that intersource variations in rates
are also introduced by legal limitations on the size of
loans granted by certain lenders in some states. This is
typically the case in the finance company sector. Since
studies of bank and finance companies indicate that
costs increase as loan size increases, but less than
proportionally, it follows that small loans cost more per
dollar of loan. 13 Thus, rates charged for finance
company personal loans are commonly graduated on the
basis of loan size, with a higher rate charged for smaller
loans. Banks, on the other hand, tend to graduate rates
only by type of loan, with average rate levels reflecting
average loan size and, perhaps, collateral. Accordingly,
under ceteris paribus conditions, an institution which
operates under restrictive loan size limits can be ex-
pected to have higher average rates of charge than an
institution which is able to make larger loans.
Rates of Charge and Availability
Finance Companies. The econometric models de-
veloped in staff studies on the personal loan market
show that rates charged for personal loans at finance
companies are influenced by a complex set of factors
involving rate ceilings, market concentration, barriers to
entry, growth rate of finance company offices and
creditors’ remedies. Because of the complexity of the
economic theory underlying the models, only a sum-
mary of the research is presented here; a detailed
analysis is properly reserved for supporting staff research
reports.
Since it is common belief that rates charged for
personal loans at finance companies are likely to be at,
or near, the legal rate ceiling, the analysis of rate
behavior focused on the difference between the average
rate ceiling and the average observed rate in each
state. 14 It was expected that the spread between the
ceiling and market rates would increase as the rate
ceiling increased, because higher ceilings are less likely to
be restrictive. This simple proposition is illustrated in the
following diagram:
Average rate
(APR)
Figure 6
This hypothesized relationship between the average rate
ceiling (computed over $100 ioan size intervals) and the
observed average rate of interest was tested on two
subsamples of states using two alternative estimates of
observed average rate. One subsample consisted of 24
states with the lowest average rate ceilings, and the
second sample consisted of the complementary group
of 24 states with the highest average rate ceilings.
(Alaska, the District of Columbia, and Hawaii were
deleted because of missing data.) The two averages of
rates for each state differed only in the weighting
procedures used to calculate the averages from a sample
of loan contracts collected during the last two weeks of
June, 1971. By one technique the average market rate
was calculated by weighting the APR for each contract
by the dollar amount of the contract, resulting in an
average rate charged for each dollar borrowed. The
alternative average rate was a simple, unweighted aver-
129
age, which represents the average rate per contract in
each state.
As one would expect, both of these observed average
rates were very closely related to the average rate ceiling
for the low-ceiling subsample of states. Indeed, nearly 80
percent of the variance in the observed weighted average
rate is accounted for by variations in the rate ceiling. As
the rate ceiling rises, both observed rates rise, but by less
than equivalent amounts. A one percentage point rise in
rate ceiling is associated with a .8 percentage point rise
in both of the average rates. Thus the relationship is
close to a one-to-one relationship, although also suggest-
ing that the absolute percentage point spread between
the observed mean rates and the mean ceiling grows as
the ceiling rises. The behavior of observed market price
is shown in the low-ceiling portion of the range between
points O and A on the horizontal axis of Figure 6 above.
For the high-ceiling subsample of states, variation in
the average rate ceiling accounted for only about 1 1
percent of the total variance in the observed market
average rates, whether weighted or unweighted. With
varying degrees of statistical significance, it is apparent
that market rates are relatively low in comparison to the
ceiling where real family income is relatively high and
average loan size is relatively large. Conversely, it appears
that where garnishment is restricted or prohibited, the
observed rates are somewhat higher than would other-
wise be the case.
The influences of growth and competitive circum-
stances are less clear because the two alternative meas-
ures of average observed interest rate yield differing
results. On average, increases in Finance company con-
centration ratios are associated with lower average APR’s
because fewer loans are granted (presumably to better
credit risks). On the other hand, higher growth rates of
finance companies are associated with a greater amount
of credit granted, but not with a significant difference in
APKs, But the two associations are interrelated. With
reference to the unweighted average APR, the interactive
effect of concentration and growth suggests that con-
centration raises the rate where growth is relatively slow.
This result is in accord with economic theory: rapid
growth of market demand is expected to foster com-
petitive behavior under most common conditions be-
cause newly entering firms have greater chances of
success and also because the rivalry among established
firms is typically more intense when a large portion of
their business is “new” to the market as opposed to
“repeat" business. Conversely, slow or negative market
growth naturally discourages the entry of newcomers
and the opportunities for market share expansion among
the established firms are substantially curtailed, both of
which stifle procompetitive incentives.
One possible explanation for the inconclusive results
regarding competition and rates may be that lenders can
exercise market power when they possess it either by
raising their prices or by limiting their extensions of
credit to include only relatively low-risk borrowers, or
both. The latter type of behavior can be called “quality
credit rationing,” and the purpose of both practices
would be to enhance profits. It is important to recognize
that “quality rationing” may be utilized instead of price
variations as a substitute means of maximizing profits
where price increases are not possible (because of law) or
not feasible (because of, say, damand conditions). The
Commission’s evidence concerning the availability of
personal loans at finance companies suggests the pres-
ence of just such behavior.
The analysis of availability in this segment of the
market was based on three alternative measures of
“availability:” the number of loans supplied per family;
the dollar value of loans supplied per family; and the
difference between the number of loans demanded and
the number of loans supplied as measured by the
proportion of loan applicants denied credit.
Since demand generally exceeds supply in this market
segment, it can be reasonably assumed that increased
number and amounts of loans per family will typically
indicate increased “availability" relative to demand.
Conceptually, the last measure of availability which may
be called the “rejection rate” is an index of “quality
credit rationing.” It also measures differences in the
extent to which supply falls short of demand and is
therefore “unavailable.” To obtain accurate and mean-
ingful data concerning rationing or rejections is very
difficult 15 because of varying definitions of what
constitutes an “application” and a “rejection”. More-
over, demand as measured by applications is not
necessarily independent of rejections policy since, over
the long run, severely restricted availability may curb
applications of many potential borrowers.
As measured by the average number of loans per
household extended during the second quarter of 1971,
it was found that, across states, availability of finance
company personal loans was relatively greater where
unemployment, concentration, and labor costs of fi-
nance company employees were relatively low, and
where rate ceilings, growth, real income, and the
intrastate variance of personal loan interest rates were
relatively high. The prohibition of garnishment and, to a
lesser degree, wage assignments also seems to have
reduced the number of loans supplied. Very similar
findings were obtained with respect to the dollar
amounts of credit supplied by finance companies, except
that in this case the tight administration of Convenience
130
and Advantage (C&A) licensing was additionally as-
sociated with reduced availability and wage assignments
had no discernable effect.
Interstate variations in the rejection rate of loan
applications are much more difficult to explain because
of certain complexities in the behavior of this measure,
But for present purposes it will suffice to demonstrate in
a simplified way the influence of a few key factors upon
this measure— legal rate ceilings, concentration, and C&A
licensing. At the same time it can be shown that the
three alternative measures of “availability” correspond
closely with each other, providing a welcome con-
sistency of results.
Exhibit 7-1 1 A presents data on the number and value
of loans extended by finance companies during the
second quarter of 1971, the estimated percentage of
loan applications rejected during the same period,
four-firm concentration ratios, the mean rate ceiling, and
the rate ceiling on a $ 500 loan for a selected group of
eight states which are among those with lowest average
legal rate ceilings. In contrast, Exhibit 7-1 IB presents
comparable data for eight states which have some of the
highest legal rate ceilings as measured on an average
($100 interval) basis. Within each rate ceiling group, the
states are further distinguished by the type of C&A
regulation: those where C&A are tightly administered
being segregated from those where C&A pose no barrier
to the entry of new firms or branch offices.
Comparison of the overall averages of the two tables
suggests that availability is substantially restricted in
states where rate ceilings are low and concentration is
high. The average rejection rate for the low ceiling states
EXHIBIT 7-11A
Low Rate Ceilings Finance Companies
C&A Other
State
(1)
$/F AM
(2)
#/FAM
(3)
Rejection j
Rate {%)
(4)
Cone. Ratio
(5)
Rate Ceiling
Mean $100
Int,
(6)
Rate Ceiling
$500 Limit
Missouri
43.84
.0419
32.33
41.2
18.13
26.62
Tennessee
38.19
.0432
! 32.46
45.0
25.16
27.29
Mean
41.02
.0426
32.40
43.1
21.65
26.96
C&A Tight
Arkansas
12,03
.0092
99.99*
85.5
10.00
10.00
Connecticut
39.49
.0370
41.85
47.4
24.32
25.94
Maine
15.63
.0180
31.24
63.3
24.56
27.66
Massachusetts
31.27
.0283
28.75
58.9
22.73
27.58
New Jersey
32.88
.0437
38.48
50.7
23.83
24.00
New York
23.49
.0237
35.05
75,2
23.83
24.82
Mean
25.80
.0267
45.89
21.55
23.33
Overall Average
29.61
.0306
42.52
58.4
21.58
24.24
‘There were no offices in Arkansas for the three companies supplying rejections data.
Source: Columns 1, 2, and 4 are data from the Commission's Survey of Consumer Credit Volume, Second Quarter, 1971, and Con-
sumer Credit Outstanding, June 30, 1971. The data for column 3 are calculated from data supplied to the Commission by
three large finance companies for the 2nd quarter of 1971 or the month of June 1971. Current borrowers applying for
extensions or increases in thqjr outstanding loans were excluded from the applications-rejections computations. Columns 5
and 6 are from C. H. Gushee, Coif of Personal Borrowing in the United States , 1971 Edition (Boston: Financial Publishing
Co., 1971) and refer to ceilings under the states' small loan laws.
151
of Exhibit 7-11 A is 43 percent compared with an
average of only 28 percent for the high ceiling states. As
measured by loan extensions per family, availability in
the low ceiling states is less than half of that in the high
ceiling states: $29.61 and .0306 on a dollars and
numbers per family basis, respectively, compared with
$72.87 and .0733. Market concentration in the low
ceiling states is much greater than concentration in the
high ceiling states— 58.4 versus 39.9 percent for the top
four firms.
These differences may in part be attributable to
concentration since, in a low rate ceiling situation, firms
with market power can engage in more quality rationing
of borrowers to reduce costs and improve profits. On the
other hand, the ultimate cause of low availability even in
such a case could be low rate ceilings because they can
create concentration by forcing small, marginal com-
panies out of business leaving larger, and possibly more
efficient, chain companies with a greater share of the
market but not necessarily greater than normal profits.
The combined effect of high concentration and entry
barriers may be seen in Exhibit 7-1 1 A by comparing the
average availability measures of (1) low ceiling states
which have no tight C&A entry barriers and also have
relatively low concentration with (2) low ceiling states in
which C&A is tightly administered and concentration is
relatively high. Although the mean ceiling is about the
same for both groups of low ceiling states (21.65 and
21.55), average dollars per family is 41.02 compared
with 25.80, average numbers of loans per family is .0426
compared with .0267, and the average rejection rate is
32.4 percent compared with 45,9 percent. Economic
theory provides explanation for this behavior: high
concentration and barriers to entry are both necessaiy
conditions for the exercise of market power, but
separately neither one alone is a sufficient condition for
the exercise of that power. Where rate ceilings are low,
such market power cannot be expressed in higher prices,
but, given the right of refusal to sell, it can be expressed
in “quality rationing” as a means of substantially
EXHIBIT 7-11B
High Rate Ceilings Finance Companies
C&A Other
State
$/FAM
#/FAM
Rejection
Rate (%)
Cone. Ratio
Rate Ceiling
Mean $100
Int.
Rate Ceiling
$500 Limit
Alabama
54.88
.1200
32.65
31.8
35.42
24.92
Hawaii
183.98
.0834
21.51
41.3
42.58
24.25
Indiana
68.77
.0592
35.23
48.8
32.85
33.49
Maryland
65.81
.0708
30.34
49.5
35.31
33.61
West Virginia
58.62
.0683
27.38
36.7
32.19
31.14
Mean ,
86.41
| .0804
29.42
41.6
| 35.67
29.48
C&A Tight
Florida
.0659
22.93
25.9
35.32
34.08
Idaho
56.05
.0672
26.45
43.4
32.11
j
33,61
Kentucky
54.52
31.35
41.7
31.77
33.61
Mean
50.32
.0616
26.91
37.0
33.07
33.77
Overall Average
72.87
.0733
28.48
39.9
34.69
31.09
Sources: See notes to Exhibit 7-11A.
132
reducing costs of risk for purposes of augmenting
profits.
Concentration thus has observable adverse effects on
supply, but legal rate ceilings seem a more important
determinant when they are especially low. For the 24
lowest average rate ceiling states referred to earlier,
market growth and rate ceilings alone accounted for 62
and 70 percent of the respective variance in dollar and
number supply per family. Since the median average rate
ceiling for all states was 27.8 percent APR, this means
that average rate ceilings lower than about 28 percent
appear to restrict credit availability directly and sub-
stantially, regardless of whatever influence other varia-
bles may have. Moreover, in testing for a relationship
such as outlined in Figure 5 of the introduction, there is
evidence that the greatest supply of credit (the maxi-
mum quantity in Figure 5) is obtained from an average
rate ceiling of 28 to 30 percent APR. This range
represents the closest approximation to the point Pc, Qc
in Figure 5 , where the rate ceiling sets a rate which
maximizes the availability of credit to borrowers. In
short, it establishes a rate ceiling low enough to prevent
higher rates based upon market power without restrict-
ing the supply of loans. Although this suggests that an
average ceiling in excess of 30 percent will actually
reduce the availability of credit, other factors (such as
unemployment, concentration growth, and real income)
are more important as determinants of supply where rate
ceilings are high. So little confidence can be attached to
proposals to lower rate ceilings below the 28-30 percent
average APR if they are recommended to “maximize”
credit availability to consumers.
Commercial Banks and Mutual Savings Banks. A
summary of staff findings concerning rate of charge in
this segment of the personal loan market can focus on
just a few key variables. Excluded from consideration
here are such potentially important policy variables as
the stringency of entry regulations and restrictions on
creditors’ remedies. Although these and similar items
may affect the performance of the banking sector in
serving the public, the analysis was frustrated by one of
two circumstances: (l)an absence of interstate varia-
tion in these matters— e.g., national chartering of banks
provides a regulatory entry option uniformly accessible
to newcomers in all states-or (2) the presence of
measurable variance, but, as with creditors’ remedies,
search for significant effects found nothing of im-
portance. 16 Indeed, most of the “nonpolicy” variables
used in attempts to explain price variations (such as real
income, average size of bank office, and the like) also
did not appear to be significant determinants of ob-
served bank personal loan rates. The only factors which
seemed of notable consequence were legal rate ceilings,
growth, and (less significantly) market concentration. To
take one example from the cross-state analysis, the
observed average APR for commercial bank $1,000
unsecured personal loans was negatively associated with
bank growth and positively associated with the legal rate
ceiling on such loans and with market concentration. ,
Measures of availability for this segment of the
market are limited to per capita quantities supplied in
terms of either dollars or numbers because rejection
rates or other measures of “quality credit rationing” are
unavailable for this institutional class of lenders. Never-
theless, since demand in this segment seems generally to
exceed supply, 1 7 so it can again be reasonably assumed
that increased absolute quantities supplied per family
will be indicative of greater availability.
Exhibits 7-12A and 7-12B show both the number and
dollar amounts of personal loan credit extended by
commercial banks and mutual savings banks (combined)
for two separate groups of selected states— 16 with
relatively low rate ceilings on unsecured personal loans
(Exhibit 7-1 2A), and 16 with relatively high ceilings
(Exhibit 7-1 2B). It can be seen that the overall average
of availability of credit in the low ceiling states is
substantially below that of the high ceiling states. In
terms of number of loans per family, the average of the
former is .0366 compared with .0453 for the latter. In
dollars it is $37.02 versus $44.82. Since the differences
in overall concentration and growth between the two
groups are slight (see the base figures of columns (3) and
(4)), it appears that relatively low legal rate ceilings may
adversely affect availability in the bank personal loan
market as they did in the finance company market.
Although the average concentration ratio appears to
be related to availability measured by the number and
amount of loans per family within each of the two
ceiling subgroups above and below the group medians,
staff econometric studies offered only moderate sup-
porting evidence that market power limited the avail-
ability of commercial bank personal loans. The averages
in Tables 7-12A and 7-12B are not truly representative
since the range of observations is large. On balance, it
would seem that differences . in market concentration
may affect availability in some states, but not per-
vasively in all states.
Credit Unions. Credit union rates and quantities
supplied seem to have little or no Impact on the
performance of banks and finance companies in this
market. A slight but significant reverse influence can be
observed, however. There is some evidence that banks
and finance companies do lose customers to credit
unions, but the cross-substitution is not great. Low rate
ceilings possibly prevent credit unions from competing
with finance companies for higher risk customers while
restrictions on membership force them to Emit their
133
EXHIBIT 7-12A
Bank Personal Loans Low Ceiling States
Below Median
States
(1)
Number of
Loans per
Family
(2)
Dollars of
Loans per
Family
(3)
Concentration
Ratio
(4)
Bank
Growth 8
(5)
Rate Ceiling
$ 1000 Unsecured
Loan
Washington
.0159
24.14
63.9
229
12.00
Maryland , . . .
.0208
31.34
49.4
231
12.00
Iowa
.0239
15.86
10.5
220
12.00
Idaho
.0258
23.72
89.3
216
11.58
New Jersey
.0293
46.65
18.9
215
11.58
Minnesota
.0329
28.02
19.1
229
11.58
Vermont
.0338
34.63
51.8
218
11.58
North Dakota
.0358
22.38
8.5
223
11.58
Mean
.0242
28.34
38.9
223
11.74
Above Median
Arkansas
.0369
20.70
16.4
247
10.00
South Carolina
.0422
34.07
53.9
244
12.68
Pennsylvania
.0422
66.09
19.2
212
11.58
New York
.0472
74.73
34.2
218
11.58
Alabama
.0515
39.02
25.0
244
10,90
Tennessee
.0542
38.55
18.6
237
11.58
West Virginia
.0548
43.53
13.6
235
11.58
Georgia
.0629
48.80
24.1
270
10.90
Mean
.0490
45.69
25.6
238
11.35
Overall Average
.0366
37.02
32.3
231
11.55
a Total bank assets in state, year-end, 1971 divided by total bank assets in state, year-end, 1961.
134
EXHIBIT 7-12B
Bank Personal Loans High Ceiling States
Below Median
1
State
(1)
Number of
Loans per
Family
(2)
Dollars of
Loans per
Family
(3)
Concentration
Ratio
-(4)
Bank
Growth 3
(5)
Rate Ceiling
$1000 Unsecured
Loan
California
.0185
26.74
54.5
218
None
Ohio
.0209
28.16
27.6
203
None
Rhode Island
.0294
47.85
90.0
188
21.00
Colorado
.0320
40.54
15.7
229
None
Utah .
.0362
30.11
63.1
193
28.64
Arizona
.0364
50.79
91.7
289
27.55
Massachusetts
.0379
54.28
15.4
222
25.39
Kansas
.0401
25.80
12.1
216
22.40
Mean .
.0314
38.03
46.3
220
Above Median
Connecticut
.0448
67,59
36.7
227
None
Texas
.0478
38.55
12.0
230
19.72
New Hampshire
.0493
50.46
19.6
261
None
Wyoming
.0560
42.08
32.3
199
23.61
New Mexico
.0620
41.54
44.6
222
22,10
Oklahoma
.0644
42.52
17.1
217
25.24
Louisiana
.0693
49.48
16.5
230
None
Maine
.0789
80.59
28.2
205
None
Mean
.0591
51.60
25.9
224
- -
Overall Average
.0453
44.82
36.1
222
a Total bank assets in state, year-end, 1971 divided by total bank assets in state, year-end, 1961.
135
406-072 0 - 73-11
lending to segments of the community with a “common
bond.” The interstate uniformity of rate ceilings pre-
vented an analysis of the relationship of rate ceilings and
availability of credit among credit unions.
One finding concerning credit union personal loan
availability is that restrictions on the use of wage
assignments, or the prohibition thereof, appear to reduce
the number and amount of credit union personal loans.
Of the several creditor remedies tested in this context,
wage assignments seem to be the only remedy of
importance, perhaps because these and wage deductions,
which are similar though not exactly the same, are
heavily relied on by credit unions as convenient and low
cost collection techniques.
Conclusions on the Personal Loan Market
The implications of the foregoing can be readily
summarized. Legal rate ceilings may reduce the price of
personal loan credit to some borrowers, but when
ceilings are sufficiently low to affect the observed
market rate in a significant way, there is a substantial
reduction in the number of borrowers included in the
legal market. Relatively low risk borrowers who remain
in the legal lending market appear to benefit from the
lower cost loans made when higher risk potential
borrowers are excluded.
There is no such trade-off when it comes to the
impact of competition. When concentration, growth,
and C&A limits on entry are ail present, lenders may be
able to exercise market powers either to raise price or to
limit the availability of credit to marginal borrowers, or
both. The price effect may, of course, be attributable to
the direct positive tie which price has with profits (up to
a limit). Profits are also inversely related to costs,
every tiling else being equal, and it is presumably for this
reason that noncompetitive market structures are as-
sociated with limitations of credit supply. It has been
emphasized that credit sources may limit the markets
they serve either by raising rates of charge or by raising
their standards of creditworthiness among the applicants
they accept. This latter policy option of adjusting the
cut-off point between accepted and rejected loan ap-
plications has been stressed because rate ceilings offer
little leeway for rate increases in the finance company
portion of the personal loan market.
The implications of these findings for public policy
seem obvious: the only truly effective way of gaining
ample supplies of personal loan credit for consumers and
reasonable rates too, is to increase competition while
simultaneously relaxing inordinately restrictive rate ceil-
ings.
In testing the extent to which variations in the
strength of creditors’ remedies influence personal loan
credit availability, three types of remedies were included
in the analysis-garnishment, wage assignments, and
confessions of judgment. Although the supply of com-
mercial bank personal loans appears immune to dif-
ferences in the legal status of these remedies, the analysis
indicates the presence of direct relationship between the
supply of finance company loans and the ease with
which garnishment may be utilized in the collection
process. Differing laws concerning wage assignments are
significantly associated with differing credit availability
only in the case of credit unions, 1 8 though there is weak
evidence that the number of finance company personal
loans is also lower where wage assignments are pro-
hibited.
COMPETITION: CONCLUSIONS AND
RECOMMENDATIONS
In light of the foregoing analysis it is easy to conclude
that performance in many consumer credit markets is
not satisfactory. As suggested in this chapter’s introduc-
tion, substantial improvements are well within reach if
reasonable changes affecting competition and rate ceil-
ings are implemented.
Conclusions
There is ample evidence indicating that competition is
impaired in a number of states by a variety of conditions
affecting all of the major types of consumer credit. A
common structural condition of these markets is that
they tend to be highly concentrated and difficult for
newcomers to enter because of relatively slow growth in
demand for credit, or legal restrictions on entry , or some
other impediment or combination thereof. By compari-
son many other state markets appear to be fairly
competitive, a judgment which is indicated not only by
the existence of contrasting structural conditions but
also by related measures of better performance.
Commission recommendations may be grouped under
five general headings— rate ceilings, entry conditions,
mergers, market restructuring, and restrictive agree-
ments. Each will be treated in turn.
Rate Ceiling Policy
The subsequent recommendation concerning the
liberalization of legal interest rate ceilings on consumer
loans in many states is grounded on considerations
which go beyond the direct adverse effects that low
ceilings appear to have on credit availability, for the
present level and structure of legal rate ceilings in most
states appears to stifle competition in several ways. In
the first place, Commission staff found that the simple
136
correlation coefficient between finance company con-
centration ratios in the personal loan market and the
average level of personal loan (average) legal rate ceilings
is -.48 for all of the 47 states included in the analysis
and -.49 for states with rate ceilings below the median.
This implies that within this institutional class of lenders
high concentration may in part be the product of
especially low legal rate ceilings. It is not certain exactly
why low rate ceilings appear to foster concentration, but
it is reasonable to speculate that they make it more
difficult for new firms to compete with established firms
by restricting their opportunity to achieve the volume of
business needed for efficient utilization of office space
and personnel during a customary “break-in” period.
Also, low rate ceilings impose upon existing lenders a
uniformity of risk acceptance and operations policy that
otherwise need not be sustained. Thus, low rate ceilings
can adversely limit the alternatives for borrowers by
standardizing the market organization of lenders of a
given type. In addition, low and moderate rate ceilings
probably offer lenders convenient focal points for
purposes of tacitly setting uniform rates, a readily
understandable form of pricing behavior that is likely to
lead to more uniform rates of charge among companies
and, under certain circumstances, higher rates than
otherwise would be possible. 1 9
Just as the level of rate ceilings may affect intra-
institutional competition, so too can the structure of
rate ceilings (as they apply to different credit sources)
affect in ter -institutional competition. When, for exam-
ple, the ceiling applicable to a given type of credit for
one class of lenders is substantially below that of
another class of lenders, the former class will be forced
to serve mainly low risk borrowers the latter, high-ceiling
class will tend to serve relatively higher risk borrowers.
This artificial segmentation of the market obviously,
restricts inter-institutional rivalry.
Entry Conditions
Of all the recommendations concerning competition
policy the most basic is to. permit freer entry. 20 With
respect to new commercial bank entry, there has been in
the past an excessive concern on the part of chartering
and regulatory authorities for the protection of the
profitability of existing bank institutions and the pre-
sumed “needs and convenience” of the public. Too little
emphasis has been given to the vigor of bank competi-
tion and relying on such competition to provide optimal
performance in terms of price and availability. The
economics of entry have been summarized by Donald
Jacobs:
If the rate of return is low in an area, no new bank
will seek to enter. Restrictions on entry in these cases
are redundant. In areas where the rate of return on
capital is high, entry restrictions may impede the free
flow of new capital. At best, the economic effects of
entry restrictions are redundant; at worst, they are
harmful. 21
The presence of deposit insurance will continue to
protect depositors’ funds and current supervisory stand-
ards will continue to preserve the safety and soundness
of commercial banks in an environment where there is
liberalized entry chartering and more vigorous competi-
tion.
Bank brandling regulations are also important in this
connection. Although it can be argued that full state-
wide branching allows the greatest freedom to banks for
market extension or branch entry, it can also be argued
that statewide brandling, especially when coupled with
high concentration, is the most detrimental of branching
policies with respect to new bank entry. 22 Besides the
possibility of pre-emptive branching on the part of
established banks within a state, statewide branching
appears generally to reduce the number of independent
banks operating in a state and consequently to foster
concentration. This serves to restrict the number of
established banks which might offer correspondent
services in assistance to newly formed banks. 23 Al-
though the Commission makes no generally applicable
recommendation concerning branch banking, because
conditions can vary among the states, it does recommend
that where statewide branching is allowed, specific steps
be taken to assure easy new entry and low concentra-
tion. Such steps would include:
1. Giving preferential treatment wherever possible to
charter applications of newly forming banks as
opposed to branch applications of dominant estab-
lished banks;
2. Favoring branching, especially the de novo branch-
ing, whether directly or through the holding
company device when such branching promotes
competition. However, banking regulators should
exercise a high degree of caution in permitting
statewide branching whether directly or through
the holding company device when such branching
decreases competition or increases economic con-
centration;
3. Encouraging established banks and regulatory
agencies to see that correspondent bank services
be made available (for a reasonable fee) to assist
newly entering independent banks, including the
provision of loan participation agreements when
needed;
4. Disallowing regional expansion by means of
merger and holding company acquisitions when
such acquisitions impair competition; recognizing
137
that statewide measures of competition are rele-
vant.
In conjunction with the foregoing the Commission
recommends, as did the President’s Commission on
Financial Structure and Regulation, that under pre-
scribed conditions savings and loan associations and
mutual savings banks be allowed to make secured and
unsecured consumer loans up to amounts not to
aggregate in excess of 10 percent of total assets.' 1 * These
lending activities should be subject to the seme examina-
tion and supervisory procedures applied to licensed
finance companies.
With respect to regulations restricting entry of fi-
nance companies in the market, the Commission finds
no value in “Convenience and Advantage” limitations on
entry. There is ample evidence indicating that these and
similar restrictions are disadvantageous to the public and
should be abolished, The Commission recommends that
the only criterion for entry (license) in the finance
company segment of the consumer credit market be
good character, and that the right to market entry not
be based on any minimum capital requirements or
convenience and advantage regulations .
Inter-institutional competition can also be en-
couraged (in a somewhat different way) by permitting
commercial banks direct access to the relatively high risk
segment of the personal loan market currently dom-
inated by finance companies. The Commission recom-
mends that direct bank entry in the relatively high risk
segment of the personal loan market be made feasible
by:
(1) Permitting banks to make small loans under
the rate structure permitted for finance companies',
(2) Encouraging banks to establish de novo small
loan offices as subsidiary or affiliated separate cor-
porate entities. Regardless of corporate structure,
these small loan offices, whether separate or within
other bank offices, should be subject to the same
examination and supervisory procedures applied to
other licensed finance companies',
(3) Exempting consumer loans from the current
requirement that bank loan production offices obtain
approval for each loan from the bank’s main office;
and ■
(4) Prohibiting the acquisition of finance com-
panies by banks when banks are permitted to
establish ,de novo small loan offices.
Mergers
In view of evidence in this chapter indicating the
adverse effects of concentration on credit market per-
formance, the Commission recommends that existing
regulatory agencies disallow mergers or stock acquisi-
tions among any financial institutions whenever the
result is a substantial increase in concentration in state
or local markets. Where regulatory agencies fail in this
respect, the Commission encourages the intervention of
the Antitrust Division of the Department of Justice to
enforce the Federal merger status. Past actions under the
Bank Merger Acts of 1960 and 1966 have been
somewhat successful in curbing increases in concentra-
tion 2 5 so no new legislation is proposed at this time. But
the Commission stresses the need for continued vigi-
lance.
The Commission recommends that inter-institutional
acquisitions be generally discouraged even though there
is no effect on intra-institutional concentration. Bank
holding companies’ acquisitions of finance companies,
for example, eliminate the acquiring banks as potential
direct competitors of small loan companies. In recent
years policies with respect to branch banking of bank
holding company acquisitions have been considerably
liberalized. The Commission believes the easiest way to
prevent increased market concentration from following
this trend is to apply rigorous competitive standards to
all bank acquisitions.
Restructuring Concentrated Markets
The foregoing recommendations will go a long way
toward improving the competitive climate in most state
and local markets. But in some cases these structural
measures may not be sufficient to restore competition or
to achieve significant entry, except perhaps in the very
long run. For this reason, the Commission recommends
that state regulatory agencies and legislatures review the
market organization of their respective financial indus-
tries after a 1 0-year trial period of earnest implementa-
tion of recommendations on market entry and concen-
tration. If, despite these procompetitive efforts, such
review discloses inadequate competition as indicated,
say, by continued market dominance by a few com-
mercial banks and finance companies or the absence of
more frequent market entries-then a restructuring of
the industry by dissolution and divestiture would prob-
ably be appropriate and beneficial.
Restrictive Arrangements
Although almost obvious, the Commission recom-
mends that antitrust policy, both Federal and state, be
alert 'to restrictive arrangements in the credit industry.
Any hint of agreement among lenders as to rates,
discounts, territorial allocations, and the like must be
vigorously pursued and eliminated. Furthermore, such
antitrust policy should not be exclusive to the Attorneys
General explicitly charged with enforcement, but should
138
be the underlying principle of the regulatory agencies
administering various aspects of the consumer credit
market, e.g., the FRB, FDIC, state banking agencies, etc.
Although, of course, some cooperative endeavors are
essential to industry operation— e.g., correspondent rela-
tionships, credit bureaus, and lenders’ exchanges-these
should not be allowed to mask unnecessary or un-
reasonable restraints, nor should agreements with no
purpose other than to restrain competition be allowed to
stand.
COST FACTORS INVOLVED IN
DETERMINING RATES AND
RATE CEILINGS
The staffs empirical evidence cited in preceding
sections indicated that relatively low rate ceilings—
ceilings which actually influence the observed rate— are
typically associated with significant reductions of credit
supply in affected state markets. In the finance company
segment of the personal loan market, for example, it was
estimated that supply per family began to fall where rate
ceilings averaged between 28 and 30 percent. Below an
average ceiling rate of about 28 percent, between 60 and
70 percent of the interstate variation in supply is
accounted for by rate ceiling variations and growth.
Similarly, supplies of revolving credit per family are
apparently below the national average where APR’s on
revolving accounts are less than 18 percent. As explained
earlier, such curtailments may be expected to occur
whenever rate ceilings impose a price insufficient to
cover the costs of extending credit. This is, of course, a
fundamental proposition that applies to the production
and sale of any service or commodity: if the price is not
sufficient to offset costs, including normal costs of
capital invested, supply is curtailed unless subsidies in
some form are provided. Therefore, it is necessaiy to
explore carefully the costs incurred in extending credit
for purposes of corroborating the availability findings
and designing recommendations for appropriate rate
ceiling,
An Overview
The composition of the rates (or revenues) at which
credit services are provided is depicted in the accom-
panying diagram. After a brief description of the nature
of costs involved available evidence concerning the
composition of costs of various forms of credit grantors
is reviewed.
}
}
Rate (revenue)
Operating costs
Acquisition costs
Costs of processing
and collecting
Bed debt losses
Taxes
Return on invested capital (cost of capital)
Operating Costs
Operating costs of a credit grantor arise from certain
basic functions that must be performed. A cost analysis
of a variety of credit grantors would reflect the same
basic functions, although there would be somewhat
different cost structures depending upon the amounts
and maturities of credit extensions and the quality of
customers served. This is an important principle. Be-
cause the processes of extending, servicing and collecting
a personal loan or financing a refrigerator or used car are
so similar, a rate ceiling on personal loans is probably
adequate to cover equivalent amounts of such sales
credit without affecting availability. Similarly, a rate
ceiling derived from an analysis of the new auto market,
where the average amount financed is around $3,000,
will probably serve other forms of secured credit where
amounts involved exceed $3,000.
To illustrate, a listing of activities relating to a retail
revolving charge account is shown in Exhibit 7-13. Two
points in the exhibit are worth noting. First, as brought
out in hearings on the Consumer Credit Protection Act,
a substantial portion of costs are not for “forebearance”
but for handling costs:
... I have been listening to this discussion today
about interest on revolving charge accounts which I
think more correctly could be called service charges
or charge rates. Because obviously there is a lot of
administrative work involved in charge accounts that
are not necessarily in other types of credit transac-
tions. 26 :
Second, most costs of providing various services listed
are unrelated to the amount of credit extended. Put
another way, most of these costs are fixed; therefore,
the smaller the dollar amount of credit involved, the
higher the operating costs as a percentage of the amount
of credit extended. In a competitive market fairly high
APR’s can be expected to be charged for extensions of
small amounts of credit, even though the actual dollar
finance charge might be quite small. These APR’s could
139
EXHIBIT 7-13
Services Provided on Revolving Credit Account at Department Stare
Services upon acquisition of account:
interview with credit department.
Preparation of revolving credit contract including terms of monthly payment and notice of service charge.
Clerance of consumer's name with local credit bureau, other retail stores* place of employment, and possible
personal references.
Decision of credit department to grant credit.
Makeup of charge plate for customer and issuance by mail.
Makeup of addressograph plate for customer, and makeup of blank monthly bill using addressograph plate.
Continuing services:
Daily authorization by credit department of all sales made in the store on revolving credit basis.
Daily processing of sales slips for each revolving credit account including filing by name in account files. These
sales slips may be for purchases under $1, with the average transaction about $4 or $5.
Daily processing of merchandise returns including filing by account.
Daily processing of payments {normally paid monthly) received at window or by mail, including filing by
account.
Continuous review of accounts for overbuying or lateness in payments.
Sending notices to delinquent customers.
Second and subsequent reviews of delinquent accounts and mailing of notices.
Monthly billing of each customer. This includes posting of all sales slips by date of purchase, deduction of
merchandise returns and cash payments, calculation of service charge and entry on the bill, drawing the flew unpaid
balance, the photographing of all original sales slips, credits, and the customer's bill, and mailing the bill.
Other miscellaneous continuing factors include the handling of changes of address, the tracing of skips, the use
of outside collectors, and the continued reexamination of accounts for degree of credit risk.
Source: Testimony of Duncan McC. Hoithausen, Consumer Credit Labeling Bill, Hearings before a Subcommittee. orvBanking and
Currency, U.S. Senate, 86th Cong., 2d Sess., (Washington, D.C.: U.S. Government Printing Office, I960), pp. 348-59.
be expected to decline (at a decreasing rate) as the size
of the credit extension grew larger.
A significant portion of total operating costs is
associated with the assumption of risk. Each time a
creditor provides credit, he is making a bet. Through
credit judgment and credit scoring systems a creditor
estimates the probability that a given applicant will be
willing and able to repay the debt. If he guesses
correctly, the revenue he receives for the credit service
provides a return on invested capital. If he guesses
wrong, he loses up to his entire investment in the
account, as well as the costs involved in its processing.
Thus, operating costs associated with the assumption of
risks are reflected both in bad debt losses and in costs of
collection efforts. Although bad debt losses are related
to the amounts of credit extended, many costs of
collection are fixed, regardless of the amount of credit
involved. It costs just as much to send a dunning letter
to collect a $25 payment as a $250 payment.
Return on Invested Capital. In any analysis of the
effect of rate ceilings it is important to recognize that
credit grantors face a highly competitive market in
obtaining funds. Because an individual creditor who
wishes to obtain borrowed or equity funds represents
only a small fraction of the demand side of money and
capital markets, he has virtually no control over the
price he must pay for funds. Given his risk class, he must
pay the market rate or do without funds. Once he has
balanced his sources of funds in an optimal manner, the
credit grantor has little control over the cost of his
invested capital (more technically, his cost of capital). If
he cannot generate adequate revenues, his firm will lose
funds and decline in market value. If by shrewd
management (or some degree of monopoly control of
the market) he is able to earn a better return than other
firms in his risk class, he will attract funds, and the firm
may grow.
A credit grantor’s cost of capital represents a required
return —a return that must be earned if the value of the
firm is to remain unchanged. Decreases in revenues that
result from lower rates of increases in operating costs
cannot be taken out of the return on invested funds
without driving those funds into other lines of business.
140
EMPIRICAL EVIDENCE OF COSTS
OF PROVIDING CREDIT
A number of studies of costs of providing consumer
credit, some of them initiated by the Commission, are
available, but most of them suffer from one inherent
problem: they do not reflect the costs of providing
credit in a free market. Mien rate ceilings are effective, a
study of the costs of operation is, in a sense, self-
fulfilling. If the rate ceiling is 1 0 percent, costs obviously
have to be low enough to permit the lender to earn the
required return on his invested funds. There may be few
lenders in the market and only a minority of consumers
who qualify for credit at that rate-but the resulting cost
structure “justifies” a price ceiling of 10 percent. If costs
were higher, the lender would soon be out of business.
Similarly, at higher rate ceilings, added competition
tends to force those credit grantors serving marginal
customers to assume more risk in order to acquire more
customers, More risk means higher costs— and once again
the measured costs may “justify” the higher price ceiling
for that particular class of credit grantors.
Commercial Banks
For several years the Federal Reserve Banks have
prepared and published a functional cost analysis in an
effort to develop reasonably standardized cost account-
ing systems to allocate income and expenses to profit
centers within cooperating commercial basis. Although
no one would represent the results as the culmination of
an exact science, the data concerning the instalment loan
function within commercial banks are instructive.
The costs of commercial banks reflect the grade of
credit risks acceptable under their established finance
rates, which are typically below their rate ceilings, Often
by choice and sometimes because of low rate ceilings,
commercial banks generally serve a less risky and,
therefore, less costly segment of the market than finance
companies. There is not, however, a clear delineation
between the markets. Commercial banks must perform
the same basic services as other credit grantors, and the
costs of many of these services are fixed, regardless of
the amount of credit extended. The importance of these
fixed costs is evident in Exhibit 7-14, which shows the
APR’s that commercial banks must earn to break even at
various sizes and maturities of loan. The maturity of a
loan is closely related to its size; that is, a consumer
seldom borrows $500 for 36 months, $2,500 for 12
months. For this reason Exhibit 7-14 portrays those
maturities most likely to be associated with the loan size
shown on the horizontal axis.
The exhibit may be interpreted as follows. Unless a
commercial bank receives at least 18 percent on a
12-month, $500 loan, its return is insufficient to cover
its average operating costs, credit losses, and the required
return on its invested capital.
Two features of the analysis produce substantial
understatement of the APR required to break even.
First, the cost of funds used in determining these data
was only 3.67 percent before taxes, a figure considerably
below any reasonable estimate of the overall cost of
capital before taxes to commercial banks. Second, the
instalment loans covered in the functional cost analysis
include all direct loans, both unsecured personal loans
and 36-month, secured new auto loans— as well as longer
term loans on boats and mobile homes. Because the risks
are probably greater on the small, unsecured loans than
on the large loans, the APR that would be required on
small loans is probably higher than shown in Exhibit
7-14.
Even without these corrections, if the curves were
extended in Exhibit 7-14 to loans below $500, the
required APR would rise well above 20 percent. These
data make clear why commercial banks are often
reluctant to make small loans, especially if they entail
much risk. In some states they are prevented from doing
so by rate ceilings. In other states they choose not to do
so because of the “image problem” of overtly charging
the high rates necessary to cover costs of providing small
amounts of credit. The exhibit also shows why lenders
that do assume higher risks on small extensions of credit,
such as consumer finance companies, find their costs of
providing credit are often quite high as a percentage of
the declining unpaid balance.
Consumer Finance Companies
The most recent data available to the Commission on
the costs of consumer finance companies (also known as
licensed lenders, personal finance companies, or small
loan companies) are derived from a continuation of a
major study by Paul F. Smith 27 and a special study for
the Commission by George J. Benston. Data from the
Smith study for 1964, shown in Exhibit 7-15, indicate
that, on average', $ 12.73 per $ 100 of average outstanding
credit was expended for “operating expenses” and $8.67
for “nonoperating expenses.” Since the average loan size
during the year these data were collected was $485 and
the probable average maturity was 1 year, it is possible
to estimate the APR required to cover total costs of
lending various loan sizes for 1 year. When “provision
for losses” is subtracted from operating expenses, the
resulting $10.46 is the estimated cost, per $100, of
putting a $485 loan on the books and servicing that loan
for a year. Multiplying the number of hundreds upon
which this estimate is based, 4.85 times the cost, $10.46,
yields a fixed operating cost per loan of $50.73, This
141
EXHIBIT 7-14
Annual Percentage Rates Required to Break Even for Various Sizes of Loan, 665 Commercial Banks
with Deposits up to $50 Million, 1970
Source: Federal Reserve System, Functional Cost Analysis 1 970 Average Banks (1971), p. A16A. Cost of funds is assumed to be
3.67 percent before taxes.
142
Note to Exhibit 7-14
Consumer Instalment Loan Break-even Points — This exhibit indicates the minimum size of loan at selected rates
and maturities that will generate income equal to average costs for such loans.
The consumer instalment loan break-even loan balances are calculated by equating income to costs by use of the
following equation:
24 (C + N CJ
X ~ ^
2iN-(C b + C m ) (N + 1)
C = Acquisition cost per loan
3
C p = Processing cost per payment
C b = Loan loss factory (7-year average)
C m = Cost of money
i = Add-on finance rate — percent per year of unpaid balance
N = Number of payment periods
X = Break-even loan size
approximate cost would be incurred for each loan The “provisions for losses” of $2,27 can be added to the
written, and serviced for 1 year, regardless of its size. nonoperating expenses of $8.67 per $100 to estimate a
EXHIBIT 7-15
Components of Finance Charges on Consumer Receivables, 1964,
(Dollars per $100 of average outstanding credit)
Amounts per $100
of average
Percentage
Item
outstanding credit
distribution
Lender's income
$21.40
Operating expenses
$12.73
100.0
Salaries
5.60
44.0
Occupancy costs
.98
7,7
Advertising
.71
5.6
Provisions for losses
2.27
17.8
Other
3.18
24.9
Nonoperating expenses (net operating income)
8.67
100,0
interest
4.17
48.2
Income taxes
2,17
25.0
Cost of equity funds
2.33
26.8
Dividends $.79
Retained
Earnings 1.53
Source: Paul F. Smith, "Recent Trends in the Financial Position of Nine Major Consumer Finance Companies,” in John M. Chapman
and Robert P. Shay, The Consumer Finance Industry: Its Costs and Regulation (New York: Columbia University Press,
1967), pp. 38, 40.
143
required percentage markup for variable expenses (ex- equivalents by size of loan up to $3,000. In addition to
penses varying directly with the amount lent). This these calculations, alternative charges are presented
markup would be 10.94 percent per annum of the assuming a 15 percent variable cost markup, which
declining unpaid principal balance, hi sum, an APR to would allow for enlargement of the market through a
cover full costs as of 1964 would allow $50.73 per loan higher degree of risk acceptance. By either markup, the
plus 10.94 percent per annum variable cost markup. The APR falls rapidly over the smaller loan sizes because of
Benston study for the years 1968, 1969, and 1970 the great relative weight of fixed operating costs, but for
confirms the validity of these approximations. the larger loan sizes these costs are “spread” more
On the basis of these cost calculations, Exhibit 7-16 evenly. The 28.43 APR for a 12-month, $500 loan here
presents the calculated dollar finance charge and APR under the 1 1 percent markup is close to the 26 percent
EXHIBIT 7-16
Finance Charges and Corresponding APR's Necessary to Recover Total Estimated Costs-^by
Size of Loan
$50 plus 11% $50 plus 15%
Finance Finance
Amount Financed Charge APR Charge APR
$100 $56,06 91.36 $58.31 94,66
200 62.12 53.14 66.62 56.72
300 68.18 39.62 74.93 43,31
400 74.24 32.66 83.24 36,43
500 80.30 28.43 91.55 32,23
600 . 86.36 25.58 99.86 29.42
700 92.42 23.53 108.17 27,39
800 98.48 22,00 116.48 25.87
900 104.54 20.80 124.79 24;68
1.000 110.60 19.82 133.10 23172
1.100 116.66 19.04 141.41 22.95
1.200 122.72 18.37 149,72 22.29
1.300 128,78 17.82 158.03 21,73
1.400 134.84 17.32 166.34 21.25
1.500 140.90 16.90 174.65 2Q;83
Average 29.76 33,57
1.600 . 146.96 16.54 182,96 20,48
1.700 153.02 16.21 191.27 2Q.15
1.800 159.08 15.93 199,58 19,88
1.900 165.14 15.67 207.89 19,62
2.000 171.20 15.45 216.20 19.39
2.100 177.26 15.23 224.51 19.18
2.200 183.32 15.04 232.82 18,98
2.300 189.38 14.86 241.13 1R82
2.400 195.44 14.70 249.44 18166
2.500 201.50 14.55 257.75 18,52
2.600 207.56 14.41 266.06 18,38
2.700 213,62 14.29 274.37 18125
2.800 219.68 14.18 282.68 18.14
2.900 225.74 14.07 290.99 18.02
3.000 231.80 13.98 299.30 17.93
Overall Average 22.38 26.26
144
rate estimated for the example of a 12-month, $500
commercial bank loan. The slightly higher rate can
probably be accounted for by the liigher level of risk
acceptance typical of finance companies.
Recognizing that loans of $100 and $200 are more
frequently made for 6- rather than 12-months, the
required APR will be higher than in Exhibit 7-16,
because costs of putting tire loan on the books and
servicing it must be recaptured over the shorter period of
time.
When these costs are compared with existing finance
company rate ceilings, it should be recalled that states
graduate their rate ceilings very differently. For this
reason the “average rate ceiling” used in the econometric
analysis was a simple average computed over $100
intervals for loan sizes lip to $1,500 (or the legal loan
size limit , whichever was smaller, with a resulting average
size of $570). Average APR’s for the upper panels of
Exhibit 7-16 are 29.76 percent and 33.57 percent for
the 11 and 15 percent nonoperating expense assump-
tions, respectively. Any loan size limit which sought to
make personal loans widely available would reach well
above $l,500-probably to $3,000 or more. The lower
panels of Exhibit 7-16 indicate that the required APR’s
would decline to 13.98 percent and 17.93 percent, while
the average APR’s would be 22.38 and 26.26 percent,
respectively. Staff studies Indicated that reductions in
amounts of personal loans supplied by finance com-
panies began with average rate ceilings of less than 28 to
30 percent. Any lower rate ceilings on the average size of
loan of $570 would apparently curtail availability
because revenues fail to cover required costs. When rate
ceilings are below the levels indicated, staff studies show
that finance companies can stay in business only by
granting larger size loans, limiting their risk acceptance
to more affluent consumers, and maintaining large
volume offices.
Further insight into costs of providing consumer
instalment credit is provided by Thomas A. Durkin’s
study for the Commission of the “small small” loan
industry in Texas. 28 Companies in this specially licensed
and regulated industry make loans of $100 or less.
Results of the analysis of revenues and costs indicate
that high rate ceilings permit firms to serve marginal,
high risk customers. The study demonstrates that the
fixed costs of providing consumer instalment credit
become an increasing higher proportion of outstanding
balance as the amount of credit extended declines.
With respect to the first point, comparison of
Exhibits 7-15 and 7-17 shows that lender’s income per
$100 of average outstanding credit was about five times
greater in the Texas small small loan industry than for
nine national chains. However, the notably higher net
bad debt expense and salaries suggest that the added
income potential led these companies to extend credit to
consumers in a significantly liigher risk category. With
respect to the second point, total operating costs
absorbed about four-fifths of the gross income of the
small small loan companies in Texas, but only three-
fifths of the gross income of the nine major chains. In
spite of their narrower margin, the Texas firms’ total
operating expenses amounted to almost 81 percent of
average outstanding, compared with less than 13 percent
for the major chains. These percentages represent the
minimum APR’s these firms would have to charge just to
recover costs of operation, with no return on capital
(interest, retailed earnings, and dividends) and no state
or Federal income taxes. Thus from a cost standpoint
the average charge to consumers of over 100 percent by
the Texas small small loan companies (on average loans
of about $65 in 1970) is as supportable as the average
charge of 21.4 percent by the nine chains (on average
loans of $485 in 1964). The variation is explained by
significant differences in the risk class of consumers
served and dollar amounts of credit extended. The
difference is not explained by higher profits among small
small loan companies. Quite the opposite. Net profits
after taxes of the small small loan companies amounted
to about 11.5 percent of equity funds in 1970,
compared with 12.2 percent for the nine chain com-
panies in 1964. 29
Retailers
Among data available in the Commission’s staff study
of costs of retailers credit operations are those prepared
by Touche, Ross, Bailey & Smart (now Touche Ross &
Co.), from a detailed analysis of costs in 1968 of 10
large department stores and five small stores. 30 During
that year the stores had combined sales of $1.2 billion
and credit sales of over $690 million.
Problems of allocating costs and revenues to the
credit function of retailers are as difficult as for
commercial banks. Commission staff members reviewed
the allocation procedures followed by Touche Ross,
found them reasonable, but would make some adjust-
ments in the concluding calculations.
First, the cost of capital derived in the study appears
to mix pre-tax and after-tax costs. 31 Recalculation on
the basis of data provided suggests that a reasonable
minimum estimate of the after-tax cost of capital (the
required return necessary to maintain the value of the
firm) is about 8.7 percent. 32 For purposes of calcula-
tion, this is rounded downward to an after-tax cost of 8
percent.
The required return of 8 percent after taxes must be
earned on the investment in the credit operation to
cover the average cost of capital, Specifically, this is the
145
EXHIBIT 7-17
Components of Finance Charges on Consumer Receivables of Small Small
Loan Industry in Texas, 1970
(Dollars per $100 of average outstanding credit)
Amounts per $100
of average
Percentage
Item
outstanding credit
distribution
Lender's income
$101,08
Operating expenses . . . .
100.0
Salaries
50.4
Occupancy & other . .
37.5
Net bad debts
Nonoperating expenses
12.1
{net operating income)
20.16
100,0
Interest
2.95
14.6
Income taxes
6.21
30.8
Cost of equity funds . .
11.00
54.6
Average loans outstanding are average monthly outstandings.
Source: Thomas A. Durkin, A High-Rate Market for Consumer Loans: The Small Small Loan
Industry in Texas (Washington D.C.: National Commission on Consumer Finance, 1972),
Table IV.
investment in accounts receivable and in credit equip-
ment, both computer and noncomputer. The data cited
seem to depict only the cost of capital on accounts
receivable. Exhibit 7-18 sets out what the Commission
belies to be a more accurate computation of the excess
of credit expenses over credit service charge income in
the Touche Ross analysis.
Credit Unions
Credit union cost data are distorted because they pay
no state or Federal income taxes and often benefit from
free space and equipment provided by the employer of
the members and from donated services of personnel.
This makes credit unions almost irrelevant for the
purpose at hand, but they should not be ignored.
During 1970, “almost three-fourths of all loans
granted by Federal credit unions were at the 1 percent
maximum [12 percent per annum].” 33 Of the income
received, about 38 percent was absorbed by operating
costs (itemized in Exhibit 7-19), with the balance
representing the return on invested capital. It is evident
from the exhibit that salaries were the largest com-
ponent of operating costs, despite donated services.
Commission interest in the availability of credit to
low income consumers led to funding a special study of
the performance of limited income and OEO-funded
credit unions. 34 These are usually Federal credit unions.
Members include those whose annual income falls within
the poverty classification established by the Federal
Office of Economic Opportunity, residents of public
housing projects, or individuals who qualify as recipients
in a community action program. Income and expenses of
629 of these credit unions in 1970 are tabulated in
Exhibit 7-19. Operating costs of limited income credit
unions amounted to almost 50 percent of total income;
the remainder was return on invested capital,
But these data do not adequately disclose the costs of
providing small amounts of cash credit to low income
consumers. A substantial portion of the “other income”
of limited income credit unions came from various
subsidies. In a special study of OEO-funded credit
unions, (a subset of limited income credit unions)
Thomas A. Cargill estimated the “rate of finance charge
that the OEO-funded credit unions [would] have to
impose on their members in the absence of any subsidy
to cover total expenses.” 35 Adding back the estimated
subsidy of $5.86 per $1 00 of outstanding credit brought
the total “real” finance charge to about $14.94 per $100
of outstanding balance, approximately 15 percent per
annum and well above the rate currently permitted
Federal credit unions. Even with the subsidy, less than
146
EXHIBIT 7-18
Revolving Credit Service Charge Revenues and Costs of
Fifteen Department Stores, 1968
(in thousands of dollars)
Credit service charge revenue $26,328.9
Pre-tax credit costs 3 23,016,1
Taxable income 3,312.8
Taxes (estimated at 50%) 1 ,656,4
Income after taxes $ 1,656.4
After-tax cost investment in accounts receivable = Required
of capital 13 and in credit equipment return
8% X ($182,687,5 + ?) =$14,615.0 + ? = Required
return
Minimum deficiency of actual return to required return =
$14,615.0 - $1,656.4 = $12,958.6
8 Exclusive of the costs of capital.
b For estimate of after-tax cost of capital, see footnote 32.
half of these credit unions paid any dividends during
1969, compared with 87 percent of all Federal credit
unions.
RATE CEILING POLICY
MEASURES RECOMMENDED
Rate ceilings in many states restrict the supply of
credit and eliminate creditworthy borrowers from con-
sumer credit markets. Some seek out less desirable
alternatives, such as low quality credit sellers and illegal
lenders. Furthermore, many borrowers who are not
rejected pay rates of charge higher than they would be
charged in workably competitive markets.
This situation could be changed by eliminating rate
ceilings and relying on competition to ensure that
borrowers pay reasonable rates for the use of credit. But
the statistical evidence considered here indicates that
competition cannot be relied upon at this point in time
to establish rates at reasonably competitive levels in
many states. Raising rate ceilings in some areas where
markets are highly concentrated would merely allow
suppliers to raise prices, accept somewhat higher risks,
but remain secure within the legal or other barriers
which assure them that their market power and mo-
nopoly profits will not be diluted.
Clearly, then, rate ceilings cannot be eliminated until
workably competitive markets exist. But, reasonably
competitive markets cannot be expected to exist where
low rate ceilings have driven many competitors from
markets. In some instances, higher rate ceilings must be
accompanied by policies to ensure that new competitors
enter the market.
The Commission recommends that each state evaluate
the competitiveness of its markets before considering
raising or lowering rate ceilings from present levels. It
has been noted that low rate ceilings appear to inhibit
the availability of credit most heavily in the personal
loan market and, most significantly, in the higher risk,
higher rate portion of that market served by consumer
finance companies. Since states with low rate ceilings
tend to be those with highly concentrated markets, the
Commission urges that any policy regarding eliminating
or raising rate ceilings in licensed lending be accom-
panied by implementing policies previously rec-
ommended to foster vigorous competition. The same
considerations dictate caution regarding attempts to
lower the rate ceilings in licensed lending. While lower
rate ceilings hi certain cases may bring about lower
average rates of charge, the resulting dominance of the
market by giant firms and restrictions on availability can
be expected to cause rates to rise to levels significantly
higher than those set by competition unless the other
policies recommended by the Commission to achieve
workably competitive markets are adopted.
For these reasons, states where current rate ceilings
constrain the development of workably competitive
147
EXHIBIT 7-19
Income and Expenses of Federal Credit Unions and Limited Income Credit Unions, 1970
(Dollar amounts in thousands)
Federal credit Limited income credit
unions unions
Amount
Percentage
distribution
Amount
Percentage
distribution
Total income
$773,000
100,0
$4,877
100.0
Interest on loans
88.6
74.0
Income from investments
9.8
10.6
Other income
1.6
15,4
Total expenses
$292,000
100.0
$2,418
100.0
Total salaries
39.4
38.3
Borrowers' insurance
13.4
11.3
Life savings insurance
8.9
9.0
League dues
2.5
2.9
Surety bond premiums
0.8
.1.0
Examination fees
2.5
3.8
Interest paid
4.6
1.5
Cost of space
2.1
4.5
Educational expense
2.0
2.0
Depreciation
2.0
1.3
Other insurance
1.2
1.3
Communications
1.9
1.5
Accounting services
2.6
1.6
Conventions & conf
1.1
0.8
Supervisory committee exp
0.6
0.3
Annual meeting expense
1.1
1.0
All other expense
Net income
$481,00
13.4
$2,459
17.9
Source: Data for all Federal credit unions are from the 1970 Annual Report of the National Credit Unions Administration; for
limited income credit unions, from Thomas F. Cargill, Performance of Limited- Income Credit Unions: 1969-1 970
(Washington, D.C.; National Commission on Consumer Finance, 1972), Table 5. These latter data are included in the totals
for Federal credit unions.
148
markets should consider revising their rate ceilings if
they seek to increase credit availability at reasonable
rates of charge. The Commission staff, through esti-
mated cost, statistical, and other studies, has determined
that a rate structure with an average APR of 22-26
percent for loans up to and including $3,000 would
provide an opportunity for developing workable com-
petition in consumer credit markets. A Commission staff
study provides guidelines for developing a graduated rate
ceiling structure to assure the offer of loans of all sizes.
States should adopt a similar approach to changes in rate
ceilings in other consumer credit markets.
The Commission recommends that policies designed
to promote competition should be given the first
priority, with adjustment of rate ceilings used as a
complement to expand the availability of credit. As the
development of workably competitive markets decreases
the need for rate ceilings to combat market power in
concentrated markets, such ceilings may be raised or
removed.
The Commission notes that those states which are
determined to provide an opportunity for workable
competition in consumer credit markets may adopt a
graduated rate structure along the lines suggested by the
Commission staff studies. 36 Those states which for
other reasons provide rate ceilings which are lower than
those discussed herein should carefully monitor the
adequacy of the availability of consumer credit within
the state, Rate ceilings below those indicated in Com-
mission studies may tend to inhibit the functioning of a
competitive market and restrict the availability of
consumer credit, Such states should also monitor the
effect on high risk borrowers since lower rate ceilings
tend to eliminate such borrowers from the legal con-
sumer credit markets.
149
Chapter 8
SPECIAL PROBLEMS OF UNAVAILABILITY
DISCRIMINATION
Because credit is so important to American con-
sumers, the Commission believes that it should be
available to every creditworthy applicant on a nondis-
criminatory basis. The Commission views credit not as a
universal right, but as a privilege for the deserving. It
believes that every consumer should have an equal
opportunity for access to the credit market and that
credit should never be denied solely because of charac-
teristics such as race, creed, color, occupation, or sex.
Because any one of these and other factors could be
used as a basis for discrimination, the Commission first
had to define what it meant by discrimination.
Definition of discrimination
Webster’s Third New International Dictionary pro-
vides two pertinent definitions of “discriminate:”
1. to make a distinction: distinguish accurately...
to use discernment of good judgment. . .
2. to make a difference in treatment or favor on a
class or categorical basis in disregard of individual
merit.
The Commission found both definitions relevant to
its deliberations on discrimination.
It is obviously in the self-interest of credit grantors to
distinguish accurately between good and bad credit
risks— between those who will repay and those who will
not— prior to granting credit. If credit grantors could
“distinguish accurately” on a case-by-case basis, they
would be able to avoid wholesale discrimination on a
class or categorical basis. They would also be able to
eliminate all bad debt losses stemming from inability to
judge their applicants’ willingness and ability to repay in
the context of future events.
An analogy to insurance points up the problem. For
instance, the following figures are quoted for automobile
insurance rates for a one-car family in a midwestern city:
Age of son or daughter
16
17
18 19
Parents, one son
$196
$187
$179
$170
Parents, one
daughter
110
106
101
96
Difference
$ 86
$ 81
$ 78
$ 74
Other factors, of course, such as the type of car and
record, if any, of driver education, would affect the
actual insurance premium in individual cases. Nonethe-
less, if other factors are held constant, as a class families
with one daughter pay much lower premiums than those
with one son. This is certainly discrimination in the
second sense of the definition.
Why do insurance companies discriminate in this
fashion? Actuarial tables show that, generally, young
men have more accidents than young women, so it is to
tire insurance companies’ self-interest to avoid writing
insurance on accident prone drivers. If they could
discriminate on a case-by-case basis in advance, they
would not write insurance on drivers about to have
accidents. But they lack perfect foresight. Because they
are unable to be certain which applicants will have ac-
cidents, they assign applicants to categories of risk. All
within a given category pay a premium rate designed for
file expected probability of accident for that group.
There are two possible alternatives to the present
“discriminatory” system. Insurance companies could
charge the same premium rate to all families, regardless
of whether the youthful driver were male or female. This
method would eliminate the class discrimination but
would fail to “use discernment or good judgment.”
Premium rate differentials represent actual experience
with young male and young female drivers. Although
many young males are careful drivers who deserve lower
premiums, relatively more young female drivers are
better insurance risks. The two-rate system is unfair to
490-072 0 - 73-12
151
some proportion of young men, but a one-rate system
would be unfair to a much higher proportion of young
women. Eliminating the present two-rate system would
introduce more discrimination than exists now.
Alternatively, auto insurance companies might be
urged (or required) to refine their categories so that
subgroups of young male drivers could be identified
according to their accident potential. There are at least
two problems with this approach, First, as groups
become smaller and smaller, the statistical validity of
experience lessens to the point at which, with only one
person to a classification, there is no valid statistical
experience to draw upon. Second, the cost of developing
a classification system, then obtaining requisite infor-
mation from each applicant and processing and evaluat-
ing the information, increases geometrically with each
additional item of information sought. Costs of further
refinements to the system would soon raise insurance
premiums, and thereby impose a new form of discrimi-
nation.
Credit grantors face the same type of problem. To
illustrate, the credit scoring sheet for one major finance
company provides 15 points if the applicant has been
employed on the same job for 8 to 14 years but only
three points if employed on the same job for 1 to 5
years. This discrimination by category lias been shown
statistically to aid in differentiating good accounts from
less desirable accounts. (Fourteen other factors enter
into- the final credit decision.) No one proposes the
finance company be required to end this form of
discrimination or, to reach for the absurd, to accept on a
random basis every third new applicant without any
discrimination “on a class or categorical basis.” Such a
system would force customers who repay their debts to
subsidize those who do not. To be able to discern risk
among credit applicants more accurately requires the use
of more than 15 variables. As the system becomes more
finely honed, fewer consumers are discriminated against
because they are classified more precisely into smaller
and smaller risk categories. But the cost of the system
increases rapidly as new variables are added, and benefits
to individual consumers are outweighed by the added
burden of costs placed on all consumers.
One advantage of a competitive economic system and
reason the Commission presses for measures to assure
competition in the consumer credit market is that
discrimination based on class distinctions is minimized in
a competitive market. If some credit grantor uses an
archaic rule of thumb to deny credit to certain classes of
consumers, it will be in the self-interest of competitors
to identify good risks among such consumers and offer
them credit. It is in the self-interest of each credit
grantor to develop ability to discriminate between po-
tentially good and bad accounts by better training of
personnel and by designing effective credit scoring
systems. Credit grantors, like insurance companies, deal
with classes of applicants and turn away some good
accounts along with bad accounts in the process. But the
goad of competition should minimize rejection of
creditworthy applicants. Sophisticated scoring systems
have been developed to do just that.
Some form of discrimination is inevitable under
either definition of the word. But discrimination based
on class or category can be minimized when competition
forces credit grantors to separate as accurately as
possible consumers who are likely to pay from those
who are likely to default.
Sex discrimination , At its hearings in May 1972, the
Commission was presented with numerous documented
accounts of difficulties women face in obtaining con-
sumer as well as mortgage credit. Because the Com-
mission study was limited to consumer credit, it trans-
mitted information concerning discrimination against
women in granting mortgage credit to various Federal
agencies with jurisdiction over mortgage lending prac-
tices: the Federal Home Loan Bank Board, the Comp-
troller of the Currency, the Federal Deposit Insurance
Corporation, the Board of Governors of the Federal Re-
serve System, Federal Housing Administration, Veterans
Administration, and Farmers Home Administration.
With respect to sex discrimination in the field of
consumer credit, testimony presented at the hearings can
be summarized as follows:
1. Single women have more trouble obtaining credit
than single men. (This appeared to be more
characteristic of mortgage credit than of consumer
credit.)
2. Creditors generally require a woman upon mar-
riage to reapply for credit, usually in her
husband’s name, Similar reapplication is not asked
of men when they marry:
Shortly after my marriage 1 wrote all the stores where I
had charge accounts and requested new credit cards with
my new name and address. Tliat’s all that had changed-
my name and address. Otherwise, I maintained the same
status— the same job, the same salary, and, presumably,
the same credit rating. The response of the stores was
swift. One store closed my account immediately. All of
them sent me application forms to open a new account-
forms that asked for my husband’s name, my husband’s
bank, my husband’s employer. There was no longer any
interest in me, my job, my bank, or my ability to pay my
own bills. 1
3. Creditors are often unwilling to extend credit to a
married woman in her own name:
. . . credit cards and accounts are virtually always issued in
the name of the husband and not tbe wife, no matter if
the woman is the applicant and is the more creditworthy
of the two. Women who inquire, upon finding their credit
152
issued to theii nonappJicant spouse, are advised flatly, as a
licensee of National BanfcAmericard advises, “Bank-
Arncrieafds ,$)»■ issued in the dame of the husband,” or
“our policy allows card In the husband’s name only.” 2
4. Creditors are often unwilling to count the wife’s
income when a married couple applies for credit;
I ana married but have a job and need transportation. 1
tried A credit iliiibh fttul WO Shlall loan companies to
finance a <ar. All said if would be my husband’s credit,
not mine, that they would go Oft. My husband has been ill
for several years and naturally has not worked steady. On
the other hand, 1 work seven days a week at two jobs (one
full tiff}?, one part time);. And i think it very unfair they
will not take that as a fact. It is getting rather monoto-
nous asking for rides home. 3
5 . Women who are divorced or widowed have trouble
rc-establislling credit. Women, who are separated
have a particularly difficult time, since the ac-
counts may still be. in. the husband's name.
The anecdotal evidence was supplemented by a
survey of 23 commercial banka conducted by the St.
Paul Department of Human Rights. A man and a woman
with virtually identical qualifications applied for a $600
loan to finance a used car without the signature of the
other spouse. Each applicant was the wage earner, and
the spouse was in school, Eleven of the banks visited by
the woman “either strictly required the husband’s signa-
ture or stated it was their preference although they
would accept an application and possibly make an
exception to the general policy .” 4 When the same banks,
plus two additional banks that would make no commit-
ment to. the female applicant, were visited by the male
interviewer, six said that they would prefer both
signatures but would make an exception for him; one
insisted on both signatures;, and six “told the male
interviewer that he, as a married man, could obtain the
loan without his wife’s signature.” 5
Many practices to which witnesses objected have been
inherited from past decades; if not centuries. They fail
to reflect the times. The ejftcnstve publicity that
accompanied the Commission’s hearings has caused
many credit grantors to reexamine their policies with
respect to the existence of 'sex discrimination. In a
competitive market, creditors- responsive to these com-
plaints will capture business from their more archaic
competitors.
However, certain changes need to be made in state
laws that hinder admission of creditworthy women to
the credit society. First, alimony, support, and dower or
curtesy laws of some states may cause creditors to
believe they are assuming undue ride by granting credit
solely on the wife’s signature. The Commission recom-
mends that states undertake an immediate and thorough
review of the degree to which their laws inhibit the
granting of credit to creditworthy women and amend
them, where necessary, to assure that credit is not
restricted because of a person’s sm Second, as creditors
point out, most state statutes fixing a graduated rate
ceiling on consumer credit transactions usually prohibit
the maintenance by creditors of separate accounts for
husband and wife. The purpose, of tills limitation is to
minimize the aggregate finance charge, It seems reason-
able to permit a husband and wife to have separate
accounts if they wish and if they are provided with a full
disclosure of the possible added costs. The National
Conference of Commissioners on Uniform State Laws
should examine the legal aspects of these restraints.
Racial discrimination
Historically, minority groups have faced discrimina-
tion in the nation’s economic and social structures.
In the early part of this century, Mack scholars
examined particular social practices that discriminated
against the black population. Later, Swedish sociologist
Gumiar Myrdai published a lengthy Study of the effects
of prejudice against minorities in tile United States. The
1954 Supreme Court decision in Brown, et al v. Board of
Education of Topeka, et at. 6 and civil rights demonstra-
tions in the mid-fifties, Starting with the Montgomery,
Alabama, bus boycott in 1955, led behavioral scientists
to deeper investigations into racial or ethnic discrimina-
tion and its effects. Many academic, political, and
popular writers then began looking into economic
practices which discriminated, against U.S. minority
groups— particularly blacks and Puerto Ricans-and
published their findings and opinions. 7
In the vanguard of such literature was Columbia
University sociologist David Caplovltz’s The Poor Pay
More. The following year Senator, Warren G. Magnuson
and Jean Carper authored The Dark Side of the
Marketplace which devoted a chapter to the economics
of the ghetto marketplace,
Frederick D. Sturdivant, alone and in collaboration
with Walter T. Wilhelm, narrowed exploration of a
nationwide problem to the LOS Artgeles area. In “Pov-
erty, Minorities and Consumer Exploitation,” 8 Sturdi-
vant and Wilhelm found that credit charges were
frequently used by merchants ip ghetto areas of Los
Angeles as a vehicle to practice economic, racial and
ethnic discrimination against instalment buyers. Their
study indicated that economic discrimination was a fea-
ture of any type of ghetto marketplace, and that within
those marketplaces price or credit discrimination might
be practiced against other minorities who went outside
their own area to shop in another ghetto business
153
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